Its Bonds, Government Bonds

JC Parets
February 28, 2021

Over the past few days, the narration around Bonds has really caught on. With bond yields across the globe recovering sharply from lows, there are a lot of questions about the current stock market rally, the impact of bonds on the bull-run, whether we should prepare for a sell-off etc.

Let's try and address some concerns through this post where we talk about the impact of bonds and the US dollar on the ongoing stock market rally.

Let's assume we know nothing about the correlations in the market and are basing our view on the simple activity of observing the historical price action and its subsequent impact.

Here we have India's 10-year Government Bond. When we look at the extremes of the movement, which comprises of the high and low clocked in the 2008 crash, the range lies between 9.30-5.25. Since then for 12 years, the range hasn't been breached and if this was any other chart with the name stricken out, one would say it's going sideways.

In the chart below, we have highlighted three instances where the bond yield has bottomed out and rallied. This has happened in 2009 and 2017 in the past. Can we expect the same in 2021?

Let's look at some more charts.

Click on chart to enlarge view.

In the next chart we have overlayed Nifty 50 over India's 10-year Bond Yield to see what has transpired at peaks and troughs and what to expect going forward.

As pointed out before, we saw breakouts in the Bonds from their lows in 2009 and 2017. So what did we see in the Indian benchmark index of Nifty 50 when the Bonds were breaking out?

Notice the vertical dashed lines and the subsequent move in Nifty. While the Index did manage to move sideways temporarily on both occasions, the long-term trend of Nifty50 remained intact. For that matter, Bonds preceded the correction in Nifty50 by more than a year. While the peaks in bonds came before those in stocks, the troughs in both asset classes have been almost coincident. So the bigger picture analysis tells us that a positive correlation has been at play, disrupting the traditional belief of "rising bond yields=stock market correction".

Going by these moves seen before, we may witness a consolidation in price but the larger positive trend may continue to play out.

What we will keep an eye out for is a rotation into defensive sectors like consumer staples and utilities. Once defensive outperformance becomes an established trend, that's when we will look for signs of a weakening equity rally.

Now let's do a revision of what we do know about the correlation between these two asset classes - Bonds and Stocks.

We know that they are inversely related. When one rises, the other falls and vice versa. But does that relationship hold true in its simplicity? Or is there another aspect to it that requires our attention?

What is it that we are really concerned with? Are we concerned with just the rise in bond yields? Or are we concerned with the rate of change of that rise? Historically when we go back and look at the charts, we saw that it was the rate of change of the rise in bond yields that is of greater importance.

For instance, when you look at the steady rise in the Indian 10-year bond yield from the last swing low in October 2020, you'll see that the steady rise did not disrupt the bull rally in stocks. On the contrary, the index witnessed one of its swiftest moves from Oct2020-Feb2021.

This means that the standard conclusion that a rise in bond yields will lead to a crash in Equities is not the right conclusion. It is the Rate of Change in bond yields that is crucial.

What happens when bond yields go up? Banks do well! So the direct beneficiary of such a move is the banking sector. Now can Banks go up with the rest of the markets crashing? Not quite likely.

But aside from bond yileds what else could disrupt the on-going market rally?

US Dollar Index.

The US Dollar Index (DXY) has been acting as a great tail-wind for the current market rally. With the steep correction in DXY, both stocks and commodities have witnessed good moves for close to a year now.

We published a post on the commodity supercycle that the charts are alluding to and the only downer to that party can be a sharp rise in DXY.

While immediate resistance in the chart below is placed at 91.40, the next level to watch out for would be 94.50.

Would this have an adverse impact on the Equity and Commodity rally we've been witnessing? Yes, that's possible.

 In the chart below we compared the Nifty 50 to DXY. There have been seven occasions in the past where the dollar has bottomed out and reversed. Among these seven, on four occasions, Nifty50 continued to rally, albeit after a pause. So the jury is out on that one. But traditionally speaking, persistent weakness in the dollar is positive for both stocks and commodities.

So this was a round up of how the rise in bond yields and the US dollar has impacted the market in the past. We are more concerned with the rate of change of that rise, rather than the absolute rise itself. A rapid increase would warrant a close observation across stocks and commodities going forward.

Thanks for reading and please let us know if you have any questions.

Allstarcharts Team

Filed Under