Increase bond market limits

If the bond market stays bearish for an extended period, negative sentiment will feed into equities

For the past 18 months, the stock market has been in a strong bull run, with a brief pause for demonetisation. Earnings have grown at less than 10 per cent during this six-quarter period, while prices moved up over 50 per cent. 

Investors are hoping for faster earnings per share (EPS) growth in the third quarter (October to December 2017). Consensus says earnings growth will be in the range of 15 to 20 per cent, which doesn’t justify the price-to-earnings (PE) valuations of 27-plus. The Union Budget is the other short-term sentiment factor; most of the smart money will commit only  after the Budget. 

Conservative investors are nervous about a possible market collapse, given discrepancy between valuations and earnings growth. Nobody can predict the timing of market phases but some signals appear when a bull market is nearing its peak. 

One is a shift in terms of buying from institutions to retail. If institutions are selling but the market indices are going up, retail is driving valuations. A period of say, 10-15 sessions when institutional attitude goes net-negative while the market goes up might presage a big correction. This signal isn’t visible as of now, since net institutional position (domestic institutions plus foreign portfolio investors) is strongly positive.  A second bearish signal is lower trading volumes overall, which indicates demand is tapering off. This might happen even with net institutional buying. If demand eases, supply of shares overcomes demand and corrections occur. Volumes remain excellent. So, there’s no sign of this either. 

A third sign is very high activity in small stocks, typically traded only by retail investors. This has happened. Small and penny stocks are making up a large chunk of market volume, both in delivery and day-trading. It indicates a certain class of retail speculators, who invariably get burnt, are out there in full force. By itself though, this doesn’t indicate a breakdown. 

There is a fourth early warning signal — unusual bond market movements. Under normal circumstances, taking zero-risk government debt as the benchmark, short-tenure bonds have lower yields than longer tenure. That makes sense — the longer the tenure, the higher the return should be. But, if the differential between long and short-tenure yield narrows, or short-term bonds actually yield more than long-tenure bonds, it often signals recession. 

Flattening or inversion of the bond yield curve is a sign of institutional unease. Rising bond yields indicate that bond market players (all institutional) expect interest rates to rise. If they’re paying more for long-tenure bonds, and inverting the yield curve, it’s usually a reliable signal. 

As it happens, yield curves are flattening — the differential between short-term and long-term yields have narrowed. Bond yields have risen across tenures in the past six months, though policy rates have not moved up.  This is due to expanded government borrowing. The Centre will borrow at least Rs 500 billion more than targeted in the 2017-18 Budget. There is also a big and widening spread between policy interest rates and government bond yields. This is also unusual — government yields are usually close to the policy rate. 

Bond market investors are in a negative feedback loop.  Every time the yield rises, they have to mark down notional losses on that portion of their bond portfolio, which they might not hold till maturity. This makes them averse to buying more bonds, and lack of demand can then drive yields up even more. Hence, the bond market is experiencing a correction that has lasted several months. 

Signals from the bond market are usually pretty accurate but lagged.  The stock market might react a lot later to similar pressures.  However, this will show up in lower bank profits, and lower returns for debt mutual funds (MFs). Banks might see lower treasury income and debt funds may see slower net asset value growth. This could have a negative impact on sentiment since retail equity investors are invested in debt MFs to a considerable extent. 

Net-net, sentiment in the equity market remains strong. There are few signs that the stock market could be headed towards a peak. But, if the bond market stays bearish for an extended period, negative sentiment will feed into the stock market. This correction could ease off if FPI limits on buying debt were raised, since they might enter in a bigger way. FPIs bought net Rs 1.48 trillion of debt in calendar 2017, compared to net equity of Rs 510 billion.  If limits were raised, they could reverse the bearish trend in bond prices.