Bonds on the Verge: Why Are Bond Yields Surging Globally? What Does It Mean for the Market?

 Bonds on the Verge: Why Are Bond Yields Surging Globally? What Does It Mean for the Market?

The foreign bond yield has been out of control over the last six months. The US 10-year yield, which is now resting at 4.75%, has risen to over 5%. The last time this level was seen was during the 2008 financial crisis, which caused the worldwide crisis at the time. However, the economic imbalances brought on by COVID-19 and the conflict are what are responsible for the present increase.

It was believed for a long time that the present imbalance was not structural and would soon be corrected. Extreme demand brought on by COVID stimulus measures and a constrained supply of commodities owing to labor shortages and constrained manufacturing capacity were identified as the root reasons of this increased inflation. However, the combined effects of the Chinese economic downturn and conflict further worsened this supply chain instability. This persistent imbalance has tested the original hypothesis during 2022–2023. While the supply chain has made some progress this year, inflation has persisted albeit doing so gradually. There is thus rising fear that interest rates will likely stay high for a considerable amount of time, thereby thwarting hopes for economic development.

The Impact of Inflation

The US CPI was expected to slightly decline to 3.3% in December 2023 and 2.4% by December 2025 from its August reading of 3.7%. This is far higher than the US Fed's 2% benchmark. As a result, the Federal Reserve (Fed), whose interest rates are now between 5.25 and 5.5%, is expected to maintain its aggressive stance. After the global financial crisis and before to the COVID era, the economy was used to a low interest rate environment. The rate on 10-year bonds ranged from 1.5% to 3%. Given the limits on both family and business expenditure, sustained expectations of inflation are likely to maintain rates above this typical range. This might be harmful to both economic growth and the stock market.

So far, the economy has maintained a steady trajectory with high levels of consumption. The third quarter of 2023 is expected to see real GDP rise by 2.4% YoY, similar to the US, as a result of significant government investment and substantial job creation. As a result of a lack of available labor in the post-COVID period, unemployment claims have stayed low. However, beginning beyond 2020, the government's financial situation has become worse. Forecasts indicate that the budget deficit would remain high through 2025, at -6% in 2023. In 2024, it is anticipated that the government debt as a share of GDP will be 100%. Government expenditure is thus anticipated to decrease during the next two to three years.

Bond yields have risen, why?

The market's need for premiums when investing in the bond market is the main driver of the current high bond yields. The government's budgetary condition is deteriorating, and the private sector is usually slowing down. By effectively reducing its reserves today, the Fed is acting as a net seller in the bond market and reversing the significant quantitative easing carried out from 2020 to 2022. While the government borrows, the economy continues to thrive and budget expenditures are maintained. Due to this dynamic, the financial market's liquidity is becoming less accessible, which raises bond rates and devalues stocks.

In order to see a decline in bond rates, there must first be a considerable decline in inflation. Although there are still aftereffects of the conflict (such as fluctuating energy and food costs) and current COVID restriction regulations, this process is still in progress. In order to achieve this aim, demand must also slow down, which global central banks are actively seeking by keeping interest rates high. There is undoubtedly a possibility of deflation in the market, however slowly. In expectation of weak demand, the price of oil has just dropped by 12% from its previous high to $84. Similar trends may be seen in the pricing of important metals like steel, copper, and zinc.

The S&P500, which has seen a 5% correction, serves as an example of how the global equities market has been indicating a slowdown over the previous two months. The economy has not yet completely felt the effects of high bond rates, and the stock market needs a clear adjustment in valuation. The S&P 500's 1-year future value is now only slightly higher than its long-term average of 19x.

Indian Market Influence

The Indian stock market is now trading somewhat above the historical average. However, given of how well the local economy is doing compared to the rest of the globe, we do not anticipate a significant correction. Additionally, the global economy is not experiencing a long-term structural problem but rather a short-term imbalance driven by aggressive government fiscal policies. Additionally, despite the challenges of inflation, private firms in India are effectively producing additional profits and continuing to retain a sound financial position. The Indian corporate's Q1FY24 was good, and the Q2 results will be much better, driven by an increase in operating profit and straight volume growth.

Vinod Nair, the author, is the Geojit Financial Services' Head of Research.