The ten year US Treasury (UST) yield is down over 100bps from highs of 3% seen in December 2013 to levels of below 2% as of 16th October 2014. This level was last seen in May 2013. The ten year UST has been on a see saw ride over the last three years, coming off from levels of over 3% to levels of below 1.5% and then climbing back to 3% and now falling to levels of close to 2%.
What does the sharp fall in ten year UST yield mean for Indian markets in the short term? The Sensex and Nifty could come under pressure as the fall in yields indicate movement away from risk assets and also lack of growth prospects for global economies. The INR may actually benefit if the USD weakens from multi year highs if markets believe that the Fed may defer rate hikes. Government bond yields will trend down as the fall in ten year UST yields is also seen as a sign of deflation globally.
In the medium term, factors such as low rates and easy liquidity would prompt markets to get back into risk assets but the overhang of lack of global growth and low inflation will weigh on bond yields. India could well see rallies in Sensex, Nifty, INR and Government Bonds if global liquidity chases emerging assets. Indian macro fundamentals are improving and that would prompt money to flow in.
In the 2011 to 2014 period, the Fed has maintained its policy rates at 0% to 0.25% though it had embarked on a third round of QE in September 2012 with an initial size of USD 40 billion a month, which was then taken up to USD 85 billion a month. As of now, the Fed is in the last leg of its QE as it had wound down QE 3 to USD 15 billion a month, starting December 2013. Fed is widely expected to stop QE in its end October meet.
Why is the ten year UST yield down from levels of 3% to current levels of 2.10%? Is it due to safe haven buying or are there fundamentals backing the move or a bit of both? The movement of other asset classes along with the fall in ten year UST yield suggest safe haven buying. US equities are down over 6% from peaks seen a month ago and USD index is up over 5% over the last three months.
The world is looking unstable at present and that is leading to safe haven buying. Uneven global growth to threat of ISIS and Ebola outbreak is hurting outlook for risk assets.
The Fed has raised its warning on unstable global growth affecting the US economy, which is relatively looking the strongest in the world at present. Bond markets are factoring in prospects of the Fed holding on to record low rates for a longer period than expected. Fed was expected to start hiking rates from July 2015 and this could be extended if global weakness continues.
At a fundamental level, the fact that the UST yield curve has flattened with three months to two year UST yields staying at levels of below 0.5% and the ten year yield coming off by 90bps suggest that markets are expecting the US economy to grow at a slower pace than expected and that inflation will not look up going forward. US CPI inflation has been around 2% over the last few months and could fall if consumer sentiment is hit on the back of a global growth slowdown. Oil prices at multi year lows are also feeding into falling inflation expectations.
