The crash in Indian markets today has been attributed to a rise in bond yields in the US. The rise in bond yields caused rout in the US equity market yesterday. Nasdaq fell 3.5% on Thursday while the S&P 500 dropped 2.4%, led lower by heavy selling in technology and communications companies. Asian markets felt the tremors of the US indices crash and ended lower. Sensex tanked 2,149 points intra day to 48,890 and Nifty lost 630 points to 14,467. Later, Sensex ended 1,939 points at 49,099 and Nifty closed 586 points lower to 14,529.
Here's a look at how the rise in bond yields impacted US equity markets.
On Thursday, the US 10-year yield climbed to 1.614 per cent -the highest in a year. Expectations of strong economic expansion and concerns over inflation led to a rise in bond yields. On a year-to-date basis, the yields have risen 16% this year. US Federal Reserve will have to either lower monthly bond-buying or hike interest rates to counter a likely rise in inflation. A rise in interest rates in US will attract foreign investors to the market. This is seen as a negative for emerging markets like India, where benchmark indices have scaled record highs on the back of strong foreign inflows, of late.
Bond yields are rising in India as well. The 10-year government bond yield climbed to 6.235 percent today.
Largely, bond yields and returns on equities are inversely related. That means rise in bond yields will lead to a fall in equity markets and vice-versa. As bond yields rise, the opportunity cost of investing in equities surges, making equities less attractive.
For example, if the 10-year bond has a yield of 7% per annum, investing in equity markets will be profitable only if one can earn above 7% there. To make it more realistic, there will be a risk premium attached to equity investments since the asset class is riskier than government bonds. If we assume the premium on equities is 5%, then 12% will act as an opportunity cost for investing in equities. Any return below 12% from equities will make them less attractive compared to the safety of money parked in government bonds.
Therefore as bond yields rise, the opportunity cost of investing in equities climbs, making them become less attractive compared to government bonds.
Global brokerage Morgan Stanley said high bond yields are not necessarily harmful for economies.
"Long bond yields reflect the growth and inflation mix in the economy. If growth is strong, bond yields are usually rising. They also rise when inflation is going higher. The impact of these two situations is different for equities," explained the brokerage in a report.
If the rise in economic growth surpasses the surge in bond yields, the share markets are expected to continue perform better, it said.
"Equities/bond valuations are at the top end of their 2010-21 ranges - a period during which India went through its deepest and longest earnings recession. If growth accelerates from here as we expect, it is likely that equities break this range on the upside, consistent with the fundamental relationship," said the brokerage.
"We think the growth cycle is turning and a rise in bond yields is consistent with rising share prices. The risks to equities are that bonds offer better value than equities at current levels and/or inflation surges," Morgan Stanley added.