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Led by the US, most global markets started to get the early quiver as Bond Yields rose to lead to the strengthening of the Dollar and as the commodity cycle continues to put pressure on the upside. With US Bond yields breaching the crucial 1.6% mark, Equities got into a Risk-off as global allocations became less attractive. Rising bond yields is inversely correlated to its prices impacting the risk premium enjoyed by Equities during these cycles

In India, the 10-year benchmark bond yield spiked up to 6.23% in March’21 from 5.94% in just 30 days. In the recently announced Union Budget, the fiscal deficit for FY 21 has been pegged at 9.5% as Government unleased bold and unprecedented steps to spur demand and put the economy back on the growth track. To fund this expansionary policy the government has also announced the borrowing roadmap which raises the expectation of higher yields and possible crowding out of private investments.

As commodity prices keep soaring through the demand recovery process in the post-vaccine period of the Covid Pandemic, inflationary expectations have started to rear up. In India, the core inflation continues to remain stubborn and with fuel prices touching an all-time high the present accommodative stance of the Central Bank may change sooner than expected. In the US, whispers of multiple interest rate hikes getting triggered from mid-2022 are already getting louder.

Typically, when interest rates move up on the back of rising inflationary expectation valuations enjoyed by stocks erode. Rising interest rates also impair corporate earnings, and the impact can be more profound for mid and small-sized corporations as their cost of funds goes up more rapidly. As yields go up the bond portfolios of banks also get negatively impacted leading to possible erosion of their treasury income and overall profitability. The Government may also be forced to borrow at higher rates with cascading negative feedback loop on the cost of funds – both wholesale and retail. Even Bond portfolios of Mutual Funds may see erosion in their NAV as bond prices go down.

There are however exceptions to such classic scenarios as there are times when Equities do well despite a sustained increase in interest rates. For example, the 10-year bond yield moved up from 6.03% in January 2003 to 7.79% by end of December 2007. During the same period, the Nifty 50 index moved up from 1100 to 6138 through one of its best bull market cycles. This was a period of healthy growth in GDP, strong corporate earnings growth, and weak dollar- all resulting in strong inflows into emerging markets including India.

These traditional co-relations also breakdown during periods of co-ordinated central bank stimulus classically in the aftermath of a black swan crisis. With abundant dollar liquidity, all asset prices start to reflate and consequently Equity markets may continue to remain at elevated levels and get well overextended.

During these times, the significance of asset allocation takes the centre stage. Investors need to opt for a more prudent approach to risk, review their investment portfolio, seek expert advice, and wisely allocate among the prominent asset classes to protect and maximize their alpha.

Written by Arindam Ghosh, Founder & CEO @Alphaniti

Arindam has been involved in key leadership positions across the financial services industry in India and Asia Pacific region across Asset Management, Wealth Management and Fintech. Views expressed are personal.

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