The stock market is a funny place to be in. Predictions come in all genres and from all corners of the market. Well, predicting markets, especially the index levels, is as futile as taking a guess on when the present pandemic will end.
That said, following certain market indicators may help you take well-informed decisions and, in this context, yield curves don’t lie. In fact, bond yields and corporate earnings are perhaps the two most important factors you should watch for at this juncture.
Under normal circumstances, a yield curve slopes upwards meaning bond yields are commensurate with maturities. Bonds with lower maturities quote lower yields and vice-a-versa. The difference between the yields of bonds having different maturities is called spreads.
Steepening or flattening of the yield curve, i.e., rising or falling spreads between short-term rates and long-term rates can hint at a potential growth-inflation scenario.
More often than not, steepening of the yield curve denotes that market participants are anticipating higher inflation and higher growth. Whereas flattening of the yield curve is often marked with potential economic uncertainties and work as a precursor to a change in the monetary policy stance of a central bank (Federal Reserve in today’s context).
At present, spreads on US sovereign bonds are narrowing. What does that indicate? Let’s find out.
The yield curve flattens when the spread between long-term interest yields and the short-term yields narrow. In other words, there’s no great incentive for investors to prefer bonds with longer maturities over those with shorter maturities. The spread between the 30-year US bonds and 10-year US bond is one of the most-widely used indicators.
Flattening of the yield curve on account of short-term interest rates increasing faster than the long term rates it is called Bear Flattener. This is a negative for the economy and stock markets. In contrast, when the flattening of the yield curve is a result of long-term yields falling faster than short term yields, it’s called Bull Flattener. Under such a scenario Federal Reserve has a scope to lower policy rates which is considered a bullish signal for stock markets.
At present many market experts are sensing that short-term yields are rise faster than long-term yields as the Fed has signaled a policy reversal. Is that a negative for the global economy and markets? Let’s navigate further.
When you juxtapose 30-year-10-year spreads with 10-year-3-month spreads, it becomes clearer that extremes on yield spreads denote a change in the economic and stock market trends. Although, the present state of spreads doesn’t paint a very gloomy picture, you might want to approach the markets cautiously.
The analysis of bond yield spreads has provided us with reinforcing findings on what we understood from Sandeep Tandon of Quant Mutual Fund.
We had recently caught up with him for a comprehensive discussion on the present macroeconomic scenario and its implications for markets. One of the key takeaways from the discussion was that growth expectations and liquidity conditions might have peaked out already.
Read all the key highlights of our discussion with Sandeep here: Bull market enters a difficult phase; how should you position your portfolio?
If the bull market has entered a challenging phase, indeed, the ability of India Inc to grow its revenues and profits will be tested meticulously over the next few quarters. Companies won’t have the advantage of a lower base effect from Q2FY22 onwards. In fact, rising input costs and shortage of key materials such as semiconductors might pose a challenge to a few industries.
It remains interesting to see how markets react to potential earnings surprises and disappointments as they might hint at possible sector rotation. As many experts believe, markets might be factoring in lots of positives already and hence would demand a sustained increase in corporate earnings.
Lofty valuations and poor earnings performance might prove precarious; conversely, moderate valuations and impressive performance may result in re-rating. Thus, be cautious, not fearful. It’s time to be selective!
You may also like to read: Lessons Atmanirbhar India needs to learn from China’s power outages
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