While bond market and equity indices are very different from each other, the yields are indicators of three key macro variables - namely - GDP growth, inflation and liquidity. All these factors are important influencers of corporate earnings, valuations and stock markets. Further, given the growing co-relation of Indian equity markets with global liquidity, overseas bond markets also can give crucial indications.
In its report dated 23rd October 2012, leading foreign brokerage house - Morgan Stanley Research tries to assess how to read the bond market indicators and what they are predicting for Indian Indices (see chart below). They have used four such indicators namely the value assigned to future growth, the traditional yield curve and two modified earnings yield gap approaches to extract information implanted in bond markets to forecast equity market outcomes (long term, mid-term as well as 12 month equity returns).
"The relative value is clearly perched in favor of equities over long bonds. Global liquidity is indicating a very bullish outcome for Indian shares. Domestic liquidity (i.e., local short rates) needs to improve further to make this a full-blown bull market in equities, if the bond markets are something to go by", the report states.
| The Indicators… | ||
| Yield Indicator | What it indicates | What it predicts |
| Value assigned to future growth | Relative value:equities vs bonds | Long-term equity returns |
| Yield Curve | Economic Growth | 12-month forward equity returns |
| Modified Yield Curve using local short rates | Domestic liquidity relative to share prices | 3-year forward equity returns |
| Modified Yield Curve using US LongYields | Global liquidity relative to Indian equity prices | 12-month forward equity returns |
| …And what they are saying about equities | ||
| Yield Indicator | What is it saying about equities right now? | |
| Qualitative | Quantitative | |
| Value assigned to future growth | Equities are better valued than bonds | 10-year CAGR in returns at 15.7% |
| Yield Curve | Equity returns likely to improve in the coming 12-months | NA |
| Modified Yield Curve using local short rates | Mid-term equity returns are likely to be middling. For fair level of returns, short term rates need to fall by 80 bps | 3-year CAGR in equity returns at 10% |
| Modified Yield Curve using US LongYields | Strong returns over coming 12-months with high probability | 12-month equity returns at 49% |