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Analyzing the Co-relation Between US Treasury Yields and Global Equities
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Ever wondered why a 10 basis points increase in the 10 Year US Treasury bond yield makes the entire global stock market take a plunge? What happens when trillions of dollars are poured into the market? What happens when the Federal Reserve’s Money Printer goes brrrr? Let’s take a look!
(Image Credits: Bloomberg)
Earlier this week, the Bond Yield on the 10-Year US Treasury bill reached a 13-month high. This resulted in a major selloff in the US and Global Stock Markets. Dow Jones finished down 0.5%, the S&P 500 index ended down 1.5% and the NASDAQ was down 3%. In today’s newsletter, we try to simplify what bond yields are and why and how do they affect stock prices.
What’s the Current Global Economic Scenario?
In the aftermath of the global pandemic, stock markets all across the globe witnessed historic levels of the selloff in March 2020. Most of the global stock indices witnessed a double-digit plunge. All major economies shrank, the unemployment numbers went up and the poorest section of the society had to rely on government aid for their survival. What began after that and is continuing to date is the biggest quantitative easing and liquidity injection that we have ever witnessed. Central Banks all across the world have poured trillions of dollars into their respective economies either by buying bonds in the money market or by providing direct monetary support to their citizens. The U.S. economy was supported by about $6.3 trillion in “stimulus” in 2020, which includes about $3.1 trillion in deficit spending and a $3.2 trillion increase in the size of the Fed’s balance sheet. US Congress has already authorized an additional $1.9 trillion in economic support so far in 2021. Together with the $900 billion authorized in December of last year, a total of $2.8 trillion has now been authorized in the past 90 days. That’s 13% of the entire U.S. gross domestic product in a single quarter.
Fear of Inflation and Subsequent Interest Rates Hike
With the amount of liquidity that has been and is currently being poured into the market, a sudden increase in Inflation is being anticipated by many economists. And given how market economics work, too much Inflation is not good for the economy or the Equity Markets. Central Banks all across the world have tried to calm down the markets and have tried to assure them that Inflation would be in the lower single digits and would not adversely affect the markets. The Federal Reserve did not change interest rates, which are currently near zero, in its policy review meet this Wednesday and said it would continue to use all the tools in its arsenal to support the still bouncing-back US economy (to be read as more liquidity for investable assets).
But they did mention the risks which might stem out of the ever-increasing liquidity in the economy, such as Inflation, and said that it is prepared to "adjust the stance of monetary policy as appropriate if risks emerge."
The Fed expects inflation to move higher, albeit temporarily, in the coming months. An increase in Inflation would trigger a chain of events that may not be favorable for the markets. Investors believe that Fed will have to step in and increase interest rates if Inflation keeps on rising. An increase in Interest Rate would result in an increase in the Bond Yield, a scenario that would suck liquidity out of Equity Markets and push it into the Bond Markets, an area that would be lucrative enough because of the increase in the Bond Yield.
What is Bond Yield and How is it related to Inflation?
Simply put, the yield of a bond is the effective rate of return that it earns. But the rate of return is not fixed — it changes with the price of the bond. To put this into perspective, consider a bond with a face value of 100 rupees and a coupon rate of 5%. What this means is that the investor would get a fixed interest at the rate of 5% per annum. Now if the bond prices increase due to an increase in their demand, the face value and coupon rate would remain the same but the market price would increase and would cost the new investor a little more, assume it to be 125 rupees. The interest rate of 5% would fetch the investor interest of 5 rupees, but since the market rate at which the investor bought is 125, the effective rate of interest will now be 4% only (5 rupees is 4% of 125). This effective rate of return is known as bond yield.
Now let us look at Bond Yield’s relationship with Inflation and Interest Rates. Inflation beyond a certain percentage would require monetary policy intervention by the Central Banks. Central Banks will have to increase the interest rates in order to curb inflation. If the interest rate in the broader economy is different from the initial coupon payment promised by a bond, market forces quickly ensure that the yield aligns itself with the economy’s interest rate. In that sense, bond yields are in close sync with the prevailing interest rate in an economy. With reference to the above example, if the prevailing interest rate is 4% and the government announces a bond with a yield of 5% (that is, a face value of Rs 100 and a coupon of Rs 5) then a lot of people will rush to buy such a bond to earn a higher interest rate. This increased demand will start pushing up bond prices, even as the yields fall. This will carry on until the time the bond price reaches Rs 125 — at that point, an Rs-5 coupon payment would be equivalent to a yield of 4%, the same as in the rest of the economy. This process of bringing yields in line with the prevailing interest rate in the economy works in a reverse manner when interest rates are higher than the initially promised yields.
How is The Increasing Bond Yield Bad for Stocks?
Bonds affect the stock market by competing with stocks for investors' dollars. Bonds are safer than stocks, but they offer a lower return. As a result, when stocks go up in value, bonds go down.
Bond yields, in a way, represent the opportunity cost of investing in equities. For example, if the 10-year bond is yielding 7% per annum then the equity markets will be attractive only if it can earn well above 7%. In fact, equity being risky there will have to be a risk premium, first of all, to be even comparable. Let us assume that the risk premium on equities is 5%. Therefore that 12% will literally act as the opportunity cost for equity. Below 12%, it does not make sense for the investor to take the risk of investing in equities as even the additional risk is not being compensated. The question of wealth creation only begins after that. As bond yields go up the opportunity cost of investing in equities goes up and therefore equities become less attractive.
What Does the Future Behold for Equity Markets?
With the amount of liquidity that has been poured into the markets, two things will happen for sure. First, inflation would increase. Second, cash would lose its value because of the increase in Inflation. Investors would look for assets that would generate good returns and help them beat inflation. That would depend on how much inflation increases and how much increase in inflation would be tolerated by the central banks around the world. In brief, if inflation continues to remain subdued and growth makes a smart recovery, markets can remain buoyant, globally. In this favorable global construct, if growth and earnings accelerate in India, this rally will sustain. On the other hand, if inflation suddenly spikes pushing the US 10-year bond yield higher, say beyond 1.8 percent, there can be a selloff in equity markets. Let’s keep our fingers crossed. Till then, let the money printer go brrrr and let retail traders have their YOLO moment on meme stocks!!