A Turn Of Events
However, something curious has been happening in the bond markets during the last three months. Bond yields, which crashed in December following the pivot, have been slowly creeping up. By Tuesday, April 2, the 30-year yield had retraced 46% of its fall, rising to 4.51%. This means that the bond markets expected interest rates in the US is on the way up, and not down, as would be implied by pivot and related commentary.
In other words, a rise in bond yields is a way for the bond markets to call the Federal Reserve’s bluff as far as ‘impending cuts’ are concerned.
At the same time, the stock markets were in a party mood, hitting new highs every week, and ensconced at their current, all-time highs.
This raises a perplexing question: How can bond markets and stock markets have such diametrically opposing views? More importantly, which of them is right?
This conundrum can only be explained by looking at two additional factors – the ballooning US government debt and stubborn inflation levels in the US.
Bond investors seem to be betting against the benign picture painted by the Fed on inflation. They seem to betting that inflation may have already bottomed out and can only go up from here, forcing the Fed to forget about rate hikes.
In this, they seem to be taking their cues from key inflation metrics — particularly Core CPI and Core PCE.
For example, the core consumer price index, which excludes food and energy costs, increased 0.4% in February compared to January. A 0.4% increase over a month implies an annualized inflation rate of 4.9% — far from the US Fed’s target of 2%.
What was more concerning was that this number was going the wrong way. In January, core CPI was at 0.3% — or an annualized rate of 3.7% — and for December, it had been at 0.2% (annualized rate – 2.4%).
In other words, inflation, instead of going down, is looking up. Little wonder then that bond investors are betting that the Fed will be in no shape to implement the 0.75 percentage point cut everyone expects this year.
Lessons for Indian Stock Investors
This raises a key question for Indian stock investors — what will be the implications of the widely anticipated cuts in US interest rates failing to show up on Indian stock markets?
Today, the global economic landscape is intricately interconnected, and developments in the US economy, particularly the Fed’s monetary policy, can have far-reaching effects on Indian stock markets.
If inflation returns to the world’s largest economy and the US Fed is forced to maintain interest rates at 5.5% or even increase them further to rein in rising inflation, it would hit India stock markets in several ways.
First, it would lead to withdrawal of money by foreign institutional investors, attracted by the higher rates of return in the US — considered a safer market than India. Moreover, there is also the minor detail about currency risk.
Higher interest rates in the US could lead to a strengthening of the US dollar, making emerging markets like India less attractive for foreign investors. Both of these could trigger FII outflows from the Indian stock market, putting downward pressure on stock prices.
Secondly, major central banks such as the US Federal Reserve have been the fountain, nay the geyser, of liquidity that have raised stock prices to their current elevated levels. If the Fed is forced to maintain high interest rates or even raise them further, this would immediately start draining global liquidity. This tightening of financial conditions would dampen stock valuations across the world, including in India.
Third, when the US increases interest rates, the RBI and ECB are also forced to increase interest rates to combat imported inflation, as was seen in 2023. This would further raise borrowing costs for Indian companies, pressuring their profitability and, in turn, their stock prices.
Moreover, many sectors of the Indian economy, such as IT and pharmaceuticals, have significant exposure to the US market, and would be hurt by any dip in US economic activity caused by higher interest rates. This was already clearly visible through 2022 and 2023, when IT companies turned ultra-cautious and stopped adding manpower.
Hence, it is important for Indian stock investors to keep an eye on US inflation numbers, such as the March CPI numbers that are expected to be released towards the end of next week. If the month-on-month core CPI number does not ease up considerably to 0.2%, it likely implies that US inflation is turning out to be stickier than the Fed, and stock investors, expected.
If, on the other hand, it remains in the 0.4% range, it should seen as a flashing red signal for Indian stock investors, who should brace themselves for a ‘higher for longer’ regime in 2024.