Fed hike, rising US Yields could trigger fresh selloff in Indian stocks

Mumbai: Hours before the ₹22,600-crore initial public offering (IPO) of the National Stock Exchange opens for public subscription this Thursday, the Federal Reserve would have decided on policy rates at its latest review.

Many analysts have pencilled in a probability north of 50% that Fed Chair Kevin Warsh would raise rates a quarter percentage point, marking the first potential hardening in more than three years.

That will have implications beyond the immediate asset class - and geography.


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First, a rise in Fed policy rates could tip the US 10-year sovereign yield - up nearly 7% in a month and now perilously close to the 5% mark - beyond a threshold considered rather rare this millennium. Investors don't often have to negotiate such levels in US bond yields, which have been used to price assets globally for nearly three quarters of a century.

The 10-year stayed above 5% for a very brief period in October 2023. Prior to that, it had crossed the threshold in 2007, about a year before Lehman Brothers became history.

So, US yields above 5% would make an emerging market like India even more unattractive for foreign institutional investors (FII), which dumped more than ₹14,400 crore of stock over the past two weeks. FIIs sold even after India harnessed record subscriptions to special forex-inflow programmes, which came with a regulatory hedging latitude, to boost its reserves and bolster a wobbling currency.

More importantly, risk-free rates at 5% in the world's biggest market for both debt and equity have ripple effects the world over.

"The reason this matters beyond fixed income is that the government bond yield is the denominator in every asset valuation in the portfolio. For most of the past 15 years, that denominator was small, stable and falling, and the discipline it imposed on equity valuations was correspondingly slight," British independent investment company Arbion wrote in a recent note. "That is no longer the case."

Steep Hurdle

US 10-year yields, until September 11 this year, have averaged 4.41% - the highest since 2007. Only on four occasions in the past two decades the gauge breached the 4% threshold.

Relative to 10-year yields, the earnings yield gap - or, the premium equity investors would pay above risk-free returns - has been negative, indicating relative overvaluation for stocks. It could widen if the US 10-year bond crosses 5%, meaning stock owners will be making even bolder earnings growth calls by owning equities.

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Based on the June quarter results, the S&P 500 earnings yield (calculated as the inverse of price-to-earnings ratios) is 3.82%. The 10-year US yield on September 11 was 4.97%, translating into a negative earnings yield gap of 115 basis points - rather unusual for a mature, developed market like the US.

To be sure, the gap is wider in India, which is insulated by robust growth and cheaper current valuations. The PE ratio of Nifty 50, based on the closing level of September 11, is 19.8. So, the Nifty 50 earnings yield works out to 5.05%, translating into a negative earnings yield gap of 197 basis points.

Hence, risks of an equity devaluation, particularly in the developed markets, are rather real - unless earnings pick up sufficiently to justify the equity risk premium. High bond yields could quietly chip away at equity allocations by conservative institutions, such as large pension funds, which run on low but steady return mandates. If unusually high risk-free rates meet their RoI needs, they don't need much exposure to riskier equities, further denting stocks.

Such a scenario could test the resilience of domestic retail investors, who now own about a fifth of Indian equities directly or indirectly, and have provided the bulwark against recent bouts of FII selling.