What caused the market fall this week?

The SENSEX and NIFTY dropped as much as 4.2% on Friday’s intra-day trade posting one of their worst single-day losses since March 2020. It wasn’t just an India problem – the decline was global. CSI 300, the Shenzen stock exchange in China, dropped 2.4%, KOSPI (Korean) index was down 2.8% and TAIEX (Taiwan) dropped 3%.

And why? This is why.

10-year government bond yields have been consistently increasing since the beginning of this year. The above chart shows the trend for Indian government bonds 10Y and US government bonds 10Y. What does that even mean? Well, government bond yields are the interest rates at which governments can borrow from the public. It is essentially what is known as ‘risk-free’ interest rates in finance. The interest rate that businesses pay is usually this ‘risk-free’ rate plus a premium for credit risk. So, it should then be obvious to you that when these bond yields rise, borrowings costs for pretty much ever corporate borrower and small business goes up.

This is what happened this week with these bond yields.

US government bond yields rose by nearly 10% on Thursday alone. And this spooked the market. Highly leveraged businesses with lots of debt in their balance sheet will be subject to higher interest costs. Liquidity, which has been driving this market rally, end up becoming scarce in a higher interest rate environment. Stock valuation calculations, which are typically performed on cashflows, are discounted using ‘cost-of-equity’ (a fancy term for discount rate), which ends up going up in an increasing interest rate environment leading to lower stock price estimates. None of this is good for businesses, nor for stock markets. And this is why we saw a massive whip on most equity indexes across the world.

But why did the yields go up?

Make no mistake, the yields are still at a historic low. In the early 2000s, treasury yields 10Y in the US were around 5.5% (it is about 1.5% today). So, the overall interest rates have been quite low for a long time now. And what this does is it reduces demand for these bonds from investors who go looking for higher yield elsewhere. So, one theory could be that the demand for long term credit and supply of capital from long term investors are dislocated. And this week’s rapid increase in yields is just one of the many to come as the mismatch corrects itself. And if this were true, then we have to brace ourselves for more pain in both equity and bond markets.

However, another popular postulate is that with increasing prices in the commodity market (oil, copper, corn etc.) investors are finally starting to see more inflation in the west. Economic growth is swiftly being restored in much of the world. And in such an environment of higher inflation and higher GDP growth, the federal reserve will start to unwind its easy monetary policy program leading to an increasing FED funds rate (the equivalent of RBI’s repo rate). Now, the FED has said nothing of this sort. It has kept saying that it will print money, keep interest rates low and support liquidity for ‘as long as takes’ (We need to thank the former ECB president and current prime minister of Italy Mario Draghi for this phrase. He said it first!). But markets are forward-looking. And they are saying that the FED will have to ‘taper’.

What of India?

Well, the RBI has already started absorbing some of the excess liquidity it created immediately after March last year. The most recent monetary policy committee meeting that was held 3 weeks ago made no real commitment to supporting government bond purchases through open market operations (Also known as OMOs, this helps reduce interest rates by creating additional liquidity in the system). As inflation has stabilised (CPI is around 4%), the RBI said that it will continue its accommodative monetary policy stance. But the bond markets aren’t buying it. Banks and financial institutions, who are the main buyers of government bonds, want better yields. This was evident in a recent auction in January when the RBI cancelled all the bids for a tranch of 2030 government bonds when bankers tried to push the yield higher. And this is why the 10Y government bond yields in India have risen from around 5.8% at the beginning of this year to around 6.2% now.

So, what now?

A slow increase in interest rates is probably required across the world. The massive swath of liquidity has increased asset prices everywhere – from housing to stocks, bond prices to bitcoin. A higher level of interest rate will bring these down to more humane levels. But this transition to a higher interest rate needs to happen much more gradually. Economic activity, capacity utilisation, employment rate and consumer spending are nowhere near pre-pandemic levels. They will take more time to come back up and till then the FED, the RBI and every other central bank in the world will continue their dovish, accommodative and supportive monetary policies. This means low-interest rates are here to stay for more time. This is one of our key predictions for 2021 and this week’s events are simply a reminder to the central banks that their job is not done yet. Nothing more.

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