Sensex earnings yield gap with 10-year US treasury bond turns negative

A negative spread between Indian equity yield and US long-term Treasury bond makes Indian equities less attractive for foreign investors and may lead to a selloff by FPIs

The Indian equity market is likely to feel the pinch of the recent rise in the benchmark government bond yield in the United States. 

The 10-year US Treasury yield has shot up by around 12 per cent, or nearly 50 basis points, since the start of this calendar year, with the majority of the rise happening in just last week. And this the spread between the Sensex earnings yield and the US benchmark bond yield from positive to negative, a shift that hasn't been seen in the past two months.

Currently, the Sensex is trading at an earnings yield of around 4.1 per cent, a slight increase from around 4 per cent at the end of December. Meanwhile, the yield on the 10-year US government bond has risen from 3.87 per cent at the end of December to 4.33 per cent (as on Tuesday; it was 4.31 per cent until 7.51 pm IST on Wednesday). The earnings yield, which is the inverse of a security’s price-to-earnings (P/E) multiple, indicates the potential dividend for an investor if the stock pays out 100 per cent of its annual profits. A higher earnings yield means a lower P/E multiple and vice versa.

A negative spread between Indian equity yield and US long-term Treasury bond makes Indian equities less attractive for foreign investors and may lead to a selloff by foreign portfolio investors (FPIs), thus causing volatility on Dalal Street.

“A rise in yields on US Treasury bonds raises the opportunity cost for investment or speculation in risk assets, such as equities, leading to a selloff. Conversely, lower yields make it more lucrative to invest in equities and fuels a rally in asset prices,” explained Dhananjay Sinha, co-head research and equity strategy at Systematix Institutional Equity.

The recent inflation trajectory in the US and comments by the Federal Reserve have diminished the chances of a rate cut in the near term, resulting in higher bond yields.

The yield spread between Indian equity and the 10-year US government bond turned negative for the first time in around 15 years, in September last year when the index earnings yield had declined to 4.14 per cent, while the 10-year American Treasury yield had climbed to 4.58 per cent. This resulted in a market selloff and a decline in stock prices and the Sensex.

However, there was a rally on Dalal Street in November and December as the benchmark government bond yield in the US cooled down sharply from the 16-year high level reached in October. The 10-year US Treasury yield had declined from a record high of 5 per cent in October 2023 to 3.87 per cent in December, triggering a market rally in India. The Sensex’s trailing price-to-earnings multiple increased from 22.35x at the end of October 2023 to a two-year high of 24.93x at the end of December 2023. Historically, there is a negative correlation between the bond yields in the US and the equity valuation in India.

The Sensex cumulatively rallied by 13 per cent in the last two months of 2023 calendar year, against a 21.5 per cent decline in the US benchmark bond yield. The index is down 0.6 per cent year-to-date in 2024 as US bond yields are once again on the rise.

The movement in the yields on US Treasury bonds is transmitted to the Indian equity market through foreign portfolio investments in equities. When bond yields decline in the US, investment in Indian equities becomes more attractive and FPIs turn net buyers, leading to a rise in stock prices and an expansion in the market’s P/E multiple. Conversely, FPIs turn net sellers and withdraw their capital when bond yields rise in the US, leading to a decline in the Sensex P/E multiple. For example, FPIs turned net sellers in September as US bond yields surged, leading to a decline in the broader market, and they were net buyers in November and December as American bond yields declined.