Why Indian investors must worry about US bond yields and the Dollar index?

5 Oct 2023 , 09:34 AM

In the last few days, the Nifty has corrected sharply after almost touching the 20,200 levels. The fall in the Nifty over the last 12 sessions has almost been vertical. Surprisingly, this comes at a time when Indian macroeconomic data flows have been better than expected. The current account deficit (CAD) at 1.1% of GDP for the first quarter was lower than expected. Similarly, the core sector growth for August 2023 was at 12.1% after reporting over 8.3% growth in the previous two months. In addition, the fiscal deficit went up only marginally in the month of August to 36% of full year target, underling the belief that India would be able to defend the fiscal deficit at 5.9% of GDP for FY24. However, despite these salutary factors, the markets have been vertically down in the last 12 trading sessions. 

It is all about the global economy

Indian markets have been vulnerable to the global economic data flows for a long time now. However, what has changed this time around is two specific measures that have gone up sharply in the last month or so. We are talking about the US 10 year bond yields and the Dollar Index (DXY). The table below captures the movement of the Nifty with the movement in the US 10 year bond yields and the dollar index in last 12 trading sessions. 

Trade Date	Nifty  Index	Dollar Index  (DXY)	US 10 year  bond Yields
15-Sep-23	20,192.35	104.77	4.286
18-Sep-23	20,133.30	105.32	4.336
20-Sep-23	19,901.40	105.20	4.303
21-Sep-23	19,742.35	105.12	4.399
22-Sep-23	19,674.25	105.36	4.494
25-Sep-23	19,674.55	105.58	4.438
26-Sep-23	19,664.70	106.00	4.531
27-Sep-23	19,716.45	106.23	4.550
28-Sep-23	19,523.55	106.67	4.608
29-Sep-23	19,638.30	106.22	4.579
03-Oct-23	19,528.75	106.22	4.579
04-Oct-23	19,436.10	107.07	4.795
Returns	-3.75%	+2.20%	+11.88%

Data Source: NSE / Bloomberg

Due to the time zone differentials, we have taken current data of NSE Nifty while the data for the US Bond yields and the US dollar index are with a one-day time lag. What do we read from this table. In the last 12 trading sessions, the Nifty is down by -3.75%. At the same time, the US dollar index has spiked by 2.20% and the US bond yields have spiked 11.88% or you can simplify it and say that the bond yields are up by about 50 basis points, which is quite a lot in a short span of just 12 days. That brings us back to the fundamental question. Is there a real linkage between the US bond yields and the dollar index on one side and the Nifty on the other side? It looks a little distant but, as we shall see later, there is a strong correlation between these variables. But, first let us look at how the US 10-year bond yields and the dollar index (DXY) are positioned.

The US bond yields recently touched 4.8% and that makes it the highest bond yield since 2007. In short, the bond yields in the US benchmark are at a 16 year high. But more interesting is the dollar index, which is a barometer of dollar strength against a basket of hard currencies. The dollar index (DXY) crossed the 107 mark for only the third time in the last 40 years. The first time was in 1985, the second time in November 2022 and it has crossed that mark for the third time in October 2023. So, it is not just random spike in the bond yields and the dollar index but a multi-year high that has been made. That is what makes this relationship with the Nifty more nuanced.

How the US bond yields impact the Nifty movement

There are several reasons why the US bond yield spike has a negative impact on the Nifty and why it is most pronounced in recent weeks. Let us first look at what explains this relationship.

• Most economists have been opining that the Indian bond yields are under check as the RBI has not been  hiking rates in sync with the Fed. However, when the US 10-year bond yields move up rapidly, it has an impact on the bond yields across the world as the US is the world’s biggest bond market. Thus, although the RBI may hold rates, the bond yields would still spike in India raising the borrowing costs for Indian corporates. That has been a key reason for the Indian markets falling. 

   

• Secondly, the rise in bond yields not only impacts the cost of funds for Indian corporates, it also impacts the valuations of Indian companies. Normally valuations of companies are done by projecting cash flows and discounting these cash flows to the present. When the bond yields go up, the weighted average cost of capital goes up and that raises the discount rate and depresses valuations.

   

• The third risk of rising US bond rates is that it makes the US bond yields a lot more attractive in risk-adjusted return terms. For example, if an investor gets 5% on US bond yields and 7.2% on 10-year bond yields in India, then their risk-adjusted choice would be the US. This is likely to result in a lot of risk-off flows and that is already visible if you look at the persistent selling by the FPIs in the last 40 days.

Apart from these three factors, the big impact of higher bond yields is that it strengthens the dollar and that is what we will look at in the dollar index implications.

Why the dollar index spike matters to Indian stock markets

A strengthening of the dollar index means that the dollar is strengthening against a basket of hard currencies. Since that is the most reliable benchmark of dollar strength, a spike in the dollar index automatically weakens the rupee, and that is already visible in the way the rupee has already gone sharply beyond 83/$. Here is how the dollar index spike impacts the Indian stock markets.

• The most obvious impact is the rupee weakness and the impact it has on portfolio flows or FPI flows. A weak rupee would make FPIs sceptical about investing in India as the market returns would get partially offset by the weakening of the rupee. The FPIs need a stable to strong rupee to defend their dollar returns and that is why FPIs normally turn net sellers when there is sharp weakening of the USDINR.

   

• The second major impact that a strong dollar has is India’s trade deficit. In the latest month, we saw the trade deficit spiking due to the weak rupee. Normally, the strong dollar increases the oil import bill and, even today, India relies on imports to meet 85% of its daily crude oil requirement. A wider trade deficit means a wider than expected CAD and that has implications for the sovereign ratings and FPI flows too.

   

• But, the biggest risk of a rising dollar index for India is the risk of imported inflation. In the last few months, India has been subjected to a lot of incremental imported inflation that gets transmitted through oil and other key commodities. That makes Indian inflation a lot stickier, something we have seen in the last 3-4 months.

However, let us not overlook the silver lining at the end of cloud. One of the biggest advantages of a strong dollar is that it makes oil cheaper. That is the reason, the price of crude has fallen sharply from $94/bbl to $86/bbl in the last couple of weeks. In an interconnected global economy, the good thing is that most challenges get offset at some point. Hopefully, this impact should be short lived in terms of its Nifty impact.