Article published on Moneycontrol on 6 July 2017. Please click here for the link
To make sense of the ‘conundrum’, there is one common factor driving markets: liquidity.
As a thumb rule, when the economy is expected to grow at a brisk pace, equity prices move up and bond yields move up as well, since demand for money would be more, thereby pushing up interest rates. Similarly, when the economy is sagging, bond yields come down as demand for money is that much lower and interest rates ease accordingly. However, the current developments in both US and Indian markets defy this convention. Let us look at the market movements.
In the US, there was a ‘preparation phase’ for a long time, on the exit from exceptionally low interest rates that was administered in the wake of the Global Financial Crisis (GFC). The ‘exit’ started with the tapering and eventual withdrawal of the bond buyback programme of USD 85 billion per month, which was meant to inject liquidity into the system. Finally, from December 2015, the US Fed FOMC started raising signal interest rates. The overnight rate, which was 0 percent to 0.25 percent at that point of time, was raised by 25 bps to 0.25 percent to 0.5 percent in December 2015. Till date, they have raised rates by 1 percent, bringing the overnight rate to 1 percent to 1.25 percent. It is expected that the US Fed will continue hiking rates, rather normalising it because they are exiting from exceptionally low rates, at an appropriate pace over the next couple of years. As per the Staff Economic Projections (SEP) of the US Fed, popularly known as the dot plot, the terminal rate at the end of the rate normalization cycle is expected to be somewhere around 3 percent.
In this situation, what do you expect? You would expect the US Treasury yield to move up, right? Now listen to this: US Treasury yield is lower now, than in December 2015 prior to the initiation of the rate hike cycle. US Treasury 10-year yield is at 2.16 percent now (26 June closing), lower than 2.2 percent-2.25 percent in December 2015. Puzzling? Former Fed chairman Alan Greenspan used a term ‘conundrum’ for this kind of situation, which cannot be explained by conventional logic. US equity markets are booming, Dow Jones is at 21,409 now and S&P 500 is at 2,439 (26 June closing). The market does not expect the economy to slow down, which may have required the US Fed to slow down rate normalization. That is to say, given the buoyancy in the equity market, the US economy is not expected to sag. The US Fed is expected to continue rate hikes at a pace appropriate for them, but the US bond market is ignoring that aspect.
Now shift to India. Situation is somewhat comparable: equity market is booming, Nifty being at 9511 and Sensex at 30958 (27 June closing), and bond yields are easing, 10-year (new) benchmark being at 6.46 percent (27 June closing). There is an apparent dichotomy; if the economy is expected to do well, the RBI may not need to cut rates to give interest rate boost to the economy, and if the economy is not as buoyant, the equity market is probably going for a PE re-rating. However, there is one fundamental difference between the developments in US and India: the RBI eased rates over the last 2.5 years and there is possibility of further policy rate cut to a limited extent. Hence, there is logic for bond yields to be on the lower side in India.
To make sense of the ‘conundrum’, there is one common factor driving markets: liquidity. Though it is not the leveraged liquidity that led to the GFC, there is enough money globally chasing assets. Any positive indication in an asset class is taken as significantly positive, e.g. equity market upside, and any relative valuation is that much more attractive e.g. US bond yield levels over Euro-zone yield levels or India G-Sec or corporate bond yield levels over emerging markets.
Message for investors: In the Indian context, stick to the asset allocation that suits your risk-return profile and horizon, you need not be unduly bothered about market levels. For equity investments, leave it to professional fund managers for picking the stocks that would benefit from the India growth story. We are the fastest growing major economy in the world, and whatever little deceleration in growth happened in the quarter Jan-Mar’17, due to demonetization or other reasons, is expected to be transient. In the bond market, inflation is undershooting expectations, even RBI’s own projections, which will keep the market supported. If you are not comfortable with volatility in your fixed income portfolio, allocate to short maturity bond funds rather than long bonds. India has a much better fundamental logic for investments than USA, driven by economic growth and easy monetary policy support.
(The writer is an independent financial advisor)