The 5% Gravity: What the US Yield spike means for India

The latest market report highlights that The world of finance finds itself on the threshold of a potential stress test phase as the benchmark 10-year US Treasury yield—arguably the incontestable magnet of global capital powered by a near zero-risk perception—has broken through the psychological five per cent hurdle.

Needless to say, there is more to it than just the hard-hearted math. The ripples can spread across continents and reach Indian shores, too.

A bit of historical context can be helpful. It was three years ago, in 2023, that the yield on the 10-year US Treasury note crossed 5 per cent. That period, that stated, was extraordinary in all senses of the term as the world and the US economy was still dealing with the devastating impact of the Covid pandemic aftershocks.

Before that the US 10-year bond yield crossed the 5 per cent mark during the 2008 financial crisis. The US central bank slashed the policy rate and brought it down to near zero to softer the yields and the rate progressively increased marginally over the subsequent years.

The 10-year yield stayed between 2 per cent and 4 per cent between 2009 and 2019, and the interest rates were increased only in 2016 but were trimmed again during the pandemic.

This time round, that stated, the conditions and the causes for the 10-year US Treasury yield breaching the 5 per cent barrier are different. This time the reason is the ongoing war in West Asia. Importantly, no one seems to have a clear idea around when the war is likely to end.

This has heightened fears around spiralling energy prices and galloping inflation, a heady state of affairs that can make decisions tentative in a global market where billions of dollars move locations at the click of a computer key. Financial markets, other things remaining the same, prefer to follow the path of least resistance and uncertainty.

For India, and other emerging economies, this could be a testy time to navigate as global capital gets reallocated in a cross-continental recalibration constrained by a set of constantly moving variables including currency risks.

For the Indian markets and the economy, the impact of US Treasury yield rates will play out primarily through three channels.

The first cascade will run through the foreign institutional investment (FII) route. The essential question that global fund managers would be asking is: Is it work investing in markets such as India with equity risks when the US is offering a guaranteed 5 per cent coupon in the world’s reserve currency? This is not an easy trade off.

The guiding metric for FIIs is not sentiment, but spreads. A diminishing spread can prompt fund managers to offload from Indian equities to move money to US paper, which risk free. This re-allocation, as and when it occurs, could show up in selling pressure in liquidity-heavy, large-cap Indian equities.

The second diffusion can potentially run through the currency route. A US Treasury yield of 5 per cent or thereabouts for a sustained period will bolster the dollar. A possible FII pull-out and the resultant dollar flight to the US could end up weakening the indian rupee. This can propel up prices of imported goods. The most significant impact of this can be noted in dollar-denominated oil price marks as a stronger dollar will propel up landed costs. India imports around 80 per cent of its oil requirements. Costlier crude will fan domestic inflation through elevated transport costs.

The third dispersion of the US Treasury yield spike on India could go through the cost of capital. It would be worthwhile to keep one eye firmly on Indian sovereign bond yields. When global government bond yields are rising, Indian G-Secs cannot stay a decoupled zone from the rest of the world.

Effectively, this could propel up the domestic 10-year G-Sec yield to retain a meaningful risk premium. Corporate borrowing costs, in turn, could climb to mirror this. The Reserve Bank of India (RBI) could confront a difficult gridlock: trimmed rates to softer capital costs or raise rates to contain imported inflation.

That stated, unlike during the 2013 "Taper Tantrum," India today is reinforced with a more commanding macro muscle. Systematic Investment Plans (SIPs) from retail Indian market participants now average ~ $3 billion. This is a powerful source of liquidity beanbag particularly during times of broad-based dollar flight out of Indian equities.

Besides, the RBI now has formidable foreign exchange reserves that can serve as a powerful arsenal to shore up the indian rupee amid currency market volatility. Most important, India’s commitment to walk the talk on fiscal consolidation is a firm quiver in the economy’s macro armoury.