Rising bond yields leave investors confused but it is the time when you must cherry-pick your stocks
The equity markets across the globe, including India, saw heavy sell-off on Friday. The Indian benchmark indices – Nifty and the Sensex – ended 3.8 per cent lower. There were two main reasons for this widespread selling: first, US air strike on Syria and, second or the more important, rising US bond yields which shot up to 1.6 per cent. This is for the second time in the week that equity markets have witnessed heavy selling in the wake of rising bond yields.
We need to understand why the firming up of bond yields affects not only equity but the debt market as well and what strategy investors, both in equity and debt markets, should follow in days to come.
US Treasury yields vaulted to their highest in a year on expectations of a strong economic expansion and related inflation. Back home, the 10-year government bond yield jumped to 6.18 per cent on February 25.
The market now expects the 10-year sovereign yields to rise to 6.40 per cent by March 2022 given that the Reserve Bank of India (RBI) may hike repo rate by 25 bps going forward if the rate and liquidity normalise in the next fiscal.
What caused the spike in domestic bond yields?
In the Union Budget 2021, the government announced that it would borrow another Rs 80,000 crore in the current fiscal year, which surprised the markets. The government plans to borrow Rs 12.06 lakh crore in 2021-22. At 6.8 per cent of gross domestic product (GDP), the fiscal deficit for FY22 is higher than expected.
The government set a fiscal deficit target of 4.5 per cent for 2025-26 in the Budget, indicating that the fiscal deficit will remain elevated. The market cannot digest all this supply itself and requires support from the RBI.
As demand for funds from the government will almost double during FY22, the interest rates are expected to move up during the year. Experts, however, say the rise will be gradual. As the rate of interest goes up, this is negative for the stock market as more and more institutional money (both domestic as well as foreign) that was deployed in the equity market during the low interest rate regime for want of more return, will once again find its way to debt and bond market, which is considered safer and less volatile than the equity market.
A sharp fall in economic activities, high uncertainty and risk aversion culled bank credit growth this fiscal. Consequently, banks put money into safe-haven G-secs much above the statutory liquidity ratio (SLR) requirement of 18 per cent of net demand and time liabilities (NDTL). Such investments rose from 25.7 per cent in March to 28.6 per cent in December 2020. But as the economy recovers, bank credit is expected to improve and so will the appetite of banks to lend to the private sector.
That could affect demand for G-secs. The rating agency CRISIL has estimated bank credit growth to double to 8-10 per cent next fiscal from 4-5 per cent this fiscal.
Simultaneously, an increase in spending, leading to dis-savings by households, could moderate deposit inflows at banks. Rising crude prices could lend an upside to yields. CRISIL expects Brent crude to rise to $50-55 per barrel in calendar 2021, almost $10 per barrel higher than in 2020.
The retail- and asset-price inflation effect
This fiscal, the RBI net absorbed Rs 4.4 lakh crore (monthly, on average) under the liquidity adjustment facility and supported the huge borrowing programme.
But an encore is unlikely next fiscal because:
Inflation could play spoilsport: While the Monetary Policy Committee (MPC) maintained its accommodative stance at the February policy meeting, it revised up its consumer price index (CPI) inflation projection for the first half of fiscal 2022 to 5-5.2 per cent from 4.6-5.2 per cent projected in December. It voiced concerns on rising input prices (including crude oil) driving up core inflation. As demand recovers, these could be increasingly passed on to retail prices.
Asset price inflation could be destabilising: The latest Financial Stability Report (FSR) of the RBI says: “While easier financial conditions do support growth prospects in the short run, the longer-term impact in terms of encouraging leverage and inflating asset prices may give rise to financial stability concerns.”
How to read the RBI’s latest signals
In January, the RBI resumed variable reverse repo rate operations, which now allows banks to park excess liquidity with it. During its February 5 review, the RBI also announced a two-step reversal of the 100 basis points (bps) cut in cash reserve ratio undertaken in March 2020. While this will gradually normalise systemic liquidity, it will also afford infusions through open market operations as and when required to support the borrowing programme.
Further, instead of immediately announcing liquidity-boosting measures to support G-secs, the RBI has shifted focus to improving demand by introducing direct retail investor participation, and extending the enhanced held-to-maturity (HTM) limits for bank holding of G-secs until 2023.
That said, global developments could lend a helping hand
In 2020, extraordinary easing by the US Federal Reserve and other major central banks gave the RBI space to enhance liquidity as well. The fact that the Fed has increased its tolerance for inflation will allow continuation of its accommodative stance. Moreover, even with the additional fiscal stimulus proposed in the US, S&P Global does not expect the Fed to tighten policy soon.
10-year yields to settle at 6.5 per cent by March 2022
Overall, supply pressures will have a bearing on the 10-year G-sec yield once the RBI starts unwinding its ultra-accommodative monetary policy stance, a recent report by CRISIL said. It said the yield is expected to settle at 6.2 per cent by March 2021 and rise to 6.5 per cent by March 2022, which would still lower than the decadal average of 7.7 per cent.
So, what should Equity investors do?
The fate of equity market is India is directly linked to liquidity provided by the foreign players, like any other emerging markets (EMs). The ample liquidity is the result of easy money policy provided by the Central Banks world over and the low interest regime as a result of it. The US Fed has discounted the rising US Bond yields and has indicated it will continue to inject the liquidity and keep interest rates low through 2023.
This along with the faster than expected recovery of Indian economy from the covid related disturbances puts India in commanding position compared to other EMs in the (Asian) region and among the EM category. VK Vijaykumar of Geojit Financial Services advised investors to convert the corrections like the one we witnessed on Friday, into an opportunity to continue to buy quality stocks in performing sectors at every dip.