Interest rates are at decadal highs - Will markets go down?

Industry Insights
1

What’s happening on the Interest rates front?

  • US 10 year yields are at 15 year highs

  • Japanese 10 year yields at 9 year highs

  • German 10 year Bund yields are 5 bps away from 12 year highs

And we’ve already started seeing gloomy articles across the board saying how bad this is for the markets.

But at the same time, Equity markets are stubborn and unwilling to go down. So, what’s happening?

What’s the generally perceived correlation between higher interest rates and equity?

  • Most of us would logically think, there’s higher inflation, so central banks raise interest rates and when interest rates go up, the cost of borrowing for governments, companies and individuals go up. Bottomline goes for a toss and this leads to lower profits or higher deficits.

  • So, naturally, we may think stocks should do badly on lower earnings and therefore Price to earnings gets corrected, plus as the interest rates are higher, investors would prefer to buy bonds as they offer comparatively higher returns when compared to the risk one is taking.

So yeah, If we were to take a overtly simplistic way, Markets should go lower and we should short the markets and make money - Sounds simple right? But, markets aren’t really that simple.

When I asked my colleague @Bhuvan about this , He said “These correlations are never static. They keep changing.”
And shared couple of charts on this point:

Correlation between S&P 500 and US 20+ year bonds:

Correlation between Nifty and Indian Government 10 year bonds:

As we can see in the above charts, we can hardly see a -0.37% negative correlation between Nifty and 10 year bonds and the correlation is surprisingly +0.44% when it comes to the US markets.

So, if you short the markets purely looking at the interest rates, you will either be making meager returns or even losses - One thing is for sure you will be disappointed. :frowning:

So, what’s holding up markets?

The thing about markets is one can never be able to pinpoint at some things and say - this is happening because of that. But let’s try anyway.

Here are some of the reasons I can think of:

US:

91% of the outstanding mortgage loans are under 5.01% in the US. Consumers are definitely facing pressure on higher interest rates when compared to the last 2 years but, below 5% seems still manageable for most of them at least till now.

Consumers who want to buy a new house using mortgage are the ones who are seeing the most pain now as the affordability is now at 40 year lows as fresh mortgage rated topped 7.15%

https://finance.yahoo.com/news/us-mortgage-rate-climbs-7-125042869.html

So, who will most likely face the biggest brunt in this? The banks - When we have 90% people locking their interest rates at 5% and below and rates closing 5% . What will the banks be left with? Extremely compressed margins and potential bad loans and therefore, are already facing downgrades from multiple credit agencies.

So, yeah, things are holding up for now. But, this time it feels like the US economy needs a helping hand from the global economy to get themselves out of this trouble.

Europe:

Things are comparatively better in Europe. Despite higher rates, The inflation is heading lower and there are hopes that we may eventually see a decent cool down in Inflation and eventually the rates going forward.

https://www.reuters.com/markets/europe/german-producer-prices-fall-60-yy-july-2023-08-21/

China:

This is where things are getting more and more interesting and murkier for the second largest economy and World’s manufacturing hub.

Here’s how things started getting messier in China in the past few years:

  • When the world was shut down due to the pandemic, there was obviously slow down in the exports due to demand destruction and also, supply chain troubles.

  • And when the world started recovering slowly in 2021, Their strict covid policies previously meant, the pandemic pain was only delayed. Added to this, things started cracking up in the real estate space starting with It’s second largest real estate developer Evergrande defaulting. It’s been 2 years since that event but the trouble is only getting worse day by day as the Chinese real estate index is down 82% from May 21 peaks.

China is also facing a geopolitical challenge where countries are moving out their manufacturing base and want to depend less on China.

Parting thoughts:

With China facing a serious threat being posed on its exports and massive construction and real estate growth based economic model, and US and co. facing issues related to higher interest rates. We are stuck between one side trying to bring down inflation with higher rates while the other side is slowing down the global economy.

And maybe that’s why markets are just confused and are just staying in the range for now.

6 Likes
2

I agree with Michael Barry, people should sell.

3

Aren’t mortgages in US floating rate types like we have in India? In US, is it fixed for the entire tenure of the mortgage?

4

They have both fixed and floating rate types. Those who locked in at lower rates are reaping the benefits now.

5

Does it remain fixed for entire loan tenure of 20-30 years?

In India, even if we take fixed rate loan, it remains fixed only till max 3 years I guess. And then again rate can get revised.

6

This article is quite good, in fact I was personally researching on the divergence in SPX and Nifty50. The real reason being the negative performance of SPX in 2022 whereas a buoyant outperformance by Nifty during the same period.

I started comparing SPX in USD and Nifty in INR and as soon as I shifted the currency of Nifty50 to USD that divergence went away.

Both In USD

image
image1500×893 95.6 KB

SPX in USD and Nifty in INR

image
image1500×893 109 KB

So the next step was to find what caused this and the obvious answer was the depreciation of INR vs USD

As long as our Fiscal policies & RBI decide to let the INR fall - our stock markets will remain elevated in USD terms. Now the people here start saying India will become a super power in X years and become the 2nd largest economy in Y years.

Fundamentally I am quite worried how we are going to achieve that with USDINR at all time highs. Its like a double edged sword - central bank cannot strengthen the INR without pissing off the equity investors.

image
image1528×893 98.9 KB

Now on the rate hikes part - the story is more complicated.

  1. US FED has gone from 0.25 to 5.5%

    image
    image730×340 3.75 KB

  2. India RBI has gone up from 4% to 6.5%

    image
    image730×340 3.9 KB

So in percentage terms 2100% vs 62.5%

I still believe RBI has not hiked enough to encourage the savings rate (first problem) and much worse is the relative attractiveness of US debt vs Indian debt. Did they get the inflation under control (second problem) as the new loan growth is not slowing down enough.

You get 5.5% in USD vs 6.5% in INR - so logically investors will shy away from Indian debt.

Combining the above 2 scenarios, my question is: do the fiscal policy makers want FIIs to invest in Indian equity alone? and ignore debt ??

If yes, setting a course of depreciating INR combined with a lower spread of RBI rate:FED rate looks good.

prove me wrong, and I am ready to change my mind!

7

I don’t think we can draw this conclusion once both indices are compared in USD. Falling currency does not imply stock market goes up relatively. Otherwise Zimbabwe stock market should have very high returns in Dollars.

1 Like
8

But you have to follow the “How”, man, why is not that important. It’s technical analysis. Scientificially, if you have evidence to believe something, you should believe it.

9

Tried finding ZSE on tradingview to pull up a comparison with SPX. Let me know if you are able to compare both in USD

My point is exactly the same, we are getting the indices pumped up artificially. Hope we dont become the next Zimbabwe.

Strength of a country is directly measured in the currency appreciation. Either we have to start billing the exports in INR (software services) or import crude oil in INR.

Using USD for both is a recipe for further deterioration.

Orange line is USDINR, blue line is USDCNY

image
image1533×893 97.5 KB

10

I did not look at the data and just assumed so. But it seems absurd to me that their stock market /asset values will appreciate more in dollar when there is hyperinflation. People try to get money out, not in. Anyway, we are nowhere near Zimbabwe. Argentina i think also had inflation issues, also Srilanka and Pakistan recently to a lesser degree.

There is no rationale behind this and no reason to expect that we will have hyperinflation anytime soon. INR has had steady reduction in value since forever, it used to be in 30s long ago. We import more than we export. Anyway i am no expert.

yeah, maybe dunno. But easier said than done. Other countries don’t need INR as they have not much use for it. Also exporting gives us USD and pays for some of our imports, so exporting in USD probably isnt bad as long as we have more imports. China has much more exports but still keeps currency from appreciating to remain competitive for exports. If currency appreciates too much then exports become less competitive. But whats happening today is probably not any worse than a decade ago, so no need for alarms i think. But savings in INR does bring more constraints.

Anyway- i am no expert so can easily be wrong on any of this.

All i am saying is that the premise of assets/stock market appreciating more (in USD/same currency) because of currency depreciation is likely incorrect and makes no sense to me. You can try to find more data and confirm/reject it, esp look at countries that were not growing much and had currency issues. Also look at India itself in last 10-15 years, since 2008 i think and probably we will have INR getting worse but Nifty not doing better than US Indices. Sometimes our market does better than them, esp in 2000 decade and sometimes not. But INR keeps depreciating.