Over the past six months, the international bonds yield has been on a haywire. The US 10-year yield has surged to nearly 5%, currently resting at 4.75%. This level was last witnessed during the global crisis of 2008, stemming from the financial catastrophe at that time. However, the current spike is driven by economic imbalances resulting from the impact of COVID-19 and the war.
For an extended period, it was presumed that the current imbalance was non-structural and would soon rectify itself. The underlying causes of this elevated inflation were attributed to extraordinary demand resulting from COVID stimulus measures and a restricted supply of goods due to labor shortages and limited production capacities. But this supply chain disruption was further exacerbated by the cumulative impacts of the Chinese economic slowdown and war. Throughout 2022-2023, this prolonged imbalance has put the initial assumption to the test. While there has been some improvement in the supply chain during the year, inflation continues to persist, albeit at a gradual pace. Consequently, there is growing concern that interest rates are likely to remain elevated for an extended period, potentially derailing prospects for economic growth.
The Inflation Effect
The US CPI was 3.7% in August, and it was forecast to marginally moderate to 3.3% in December 2023 and to 2.4% by Dec 2025. This is much above the US Fed threshold level of 2%. Hence, the Federal Reserve (Fed) is likely to stay hawkish and hold the rates high, which are currently at 5.25 – 5.5%. The economy was accustomed to a low interest rate era, post-global crisis, and before the COVID period. The 10-year bond yield range was 1.5% to 3%. Sustained expectations of inflation are likely to keep yields above this conventional range, potentially detrimental to economic growth and the stock market, as both household and corporate spending face constraints.
The economy has maintained a stable trajectory thus far, with vibrant spending levels. Like in the US, 2.4% YoY real GDP growth forecasted in the third quarter of 2023 is due to high job generation and government spending. Jobless claims have remained low due to a shortage of available workers in the post-COVID era. But the fiscal position of the government has deteriorated since post 2020. The fiscal deficit is forecast to be -6% in 2023 and stay high until 2025. Govt debt as a percentage of GDP is expected to reach 100% in 2024. As a result, government spending is expected to slowdown over the next 2-3 years.
Why have Bond Yields Risen?
The prevailing high bond yields are primarily driven by the market demands for premiums when investing in the bond market. The private economy is generally slowing down, and the govt’s fiscal position is weakening. The Fed is a net seller in the bond market, undertaking a reversal of the heavy quantitative easing done from 2020 to 2022 by practically cutting its reserves today. While the government is borrowing to sustain budget expenditures and stay put the economy growth. This dynamic is diminishing the availability of liquidity in the financial market, thereby increasing bond yields and reducing stock market valuations.
Primarily, to witness a reduction in bond yields, a substantial decrease in inflation is necessary. This process is unfolding, albeit with the lingering impact of the war (volatility in energy & food prices) and ongoing COVID restriction policies exerting a trailing effect. Additionally, achieving this goal necessitates a slowdown in demand, which world central banks are actively pursuing by maintaining high interest rates. Surely, though slowly, it may develop a risk of deflation in the market. Recently, the crude price has collapsed by 12% from its recent high to $84, in anticipation of low demand. Similar patterns are visible in key metal prices like copper, zinc, and steel.
Over the past two months, the global equity market has been signaling a slowdown, as exemplified by the S&P500, which has experienced a 5% correction. However, the full impact of elevated bond yields has not yet fully permeated the economy, and the stock market requires a distinct moderation in valuation. The current 1-year forward valuation of S&P500 is just marginally above the long-term average of 19x.
The Indian Market Effect
Indian stock market is also trading just above the long-term average. But we don’t foresee a thick correction because the local economy is running smoothly and running at a much better place than rest of the world. And global, too, is not in a long-term structural issue but rather a short-term imbalance led by high government fiscal policy. Furthermore, private corporations in India continue to maintain a healthy financial position and are successfully generating extra profits despite the pressures of inflation. The Q1FY24 for Indian corporate was strong, and a stronger result will be announced in Q2 led by expansion in operating margin and upright volume growth.
First published in The Mint