How high have US treasury bond yields surged? When was the last time they were at these levels?
When it rains it pours! US bond investors will attest to that. The multi-decade-long bond bull market which peaked out in 2020, has now reversed with ferocity. Consider this, the US 30-year bond which had a yield of around 9 per cent in 1988, had dipped to below 1 per cent in 2020 (when yields decline bond prices go up). In this intervening period the risk-free 30-year bond index had outperformed the stock market benchmark, S&P 500 total return index!
With the 30 year bond now yielding 4.96 per cent, it is now at levels last seen in 2007. So is the 10 year bond which is yielding 4.79 per cent.
What is causing the increase in yields?
Three main factors. Persistent inflation, avalanche of bond issuance, and global macro/geopolitical factors.
When it comes to persistent inflation, there are two drivers pushing yields up. Investors now believe the US is likely to have long-term inflation around 3 per cent, with changed structural dynamics in the global economy post covid. For holding bonds they want compensation for that inflation and a premium over that. Typically investors in 10-year yields may expect at least a 1.5 per cent premium over inflation according to famous bond investor and founder of PIMCO – Bill Gross. The other driver is the concern that the Fed’s pause on rate hikes may be premature. And so the maxim ‘if Central Banks don’t do their job, the markets will do it for them’, appears to be playing out.
As per a report by a US government watchdog group, the US fiscal deficit for FY23 (ending September) has doubled to two trillion from around one trillion in FY22. While there are some differences in this government estimates due to timing factors, it nevertheless reflects a crazy level of increase in spending. With the Fed too not doing QE/buying bonds anymore, the flood of bond issuances to fund the spending has further altered the supply-demand landscape for bonds.
Add to it the fact that the US Treasury drained out its Treasury General Account (view it as government’s savings account with the Fed) when the debt ceiling deadlock prevented it from raising funds. Now it is also filling up the TGA to its comfort levels of $500-600 billion in earnest by selling bonds. It tries to maintain a minimum balance, amongst other reasons for emergencies as well.
And finally the global factors. Reports indicate China has been reducing its holdings of US bonds. This could be due to a combination of economic as well as geopolitical factors. Further, there are risks that Japanese holders of US treasury bonds (large holders) may unwind as bond yields in Japan increase making the US investment less attractive. Many economists are of the view that Japan’s Central Bank may be forced to abandon its yield curve control and allow yields to move up as macro economic/inflationary pressures mount.
Why are equity markets selling off?
Higher risk free yields make risk assets less attractive. According to Warren Buffet, high interest rates act like gravity on stock prices.
Remember the time around covid-19 (CY20) when interest rates were so low and equities zoomed with many market participants claiming there were no alternative to equities? Now bonds are emerging as compelling alternatives to equities.
How is Indian equity market impacted by this?
FPI selling in equities has been happening since the time US bond yields shot up post the Fed meet in September. Indian equity markets while have corrected from peak, have still fared relatively better than global peers. Domestic buying has cushioned our markets from steeper fall.
But the question to ponder is can FPI selling get more aggressive? The one-year forward earnings yield (1/PE) of Nifty 50 is around 4.7, on par with risk-free US 10-year treasury yield. That makes the Indian equity markets unattractive for the FPI.
What can lead to cooling of the US treasury bond yields?
Unfortunate as it may, some market participants believe the level of volatility or spike in bond yields may lead to a credit event causing an abrupt slowdown in economy which will trigger rate cuts/QE by the US Fed.
But outside of this and what some may term extreme views, the plausible path for cooling of yields is that the current levels of interest rates will slow down the economy enough or result in a mild recession next year, resulting in cooling of inflation. This will consequently result in cooling of bond yields as well.
But do watch out for the risk of stagflation where economy could be in recession, but inflation remains high like it happened in the 1970s in countries like US and UK.