US 10-year bond yields: How does it impact the stock market?

The Indian equity market in the third week of October was trading at around 19,800 levels. Then came the news that the US 10-year bond yields have crossed the 5% mark. What happened next? The market fell as if there was no support, and within a week (26 October), the Nifty was down nearly 1,000 points to 18,850 levels. 

Did you wonder how a US 10-year bond yield rise impacts the Indian market to this extent? For all who wondered, this article is for you. In this article, we will understand the US 10-year bond yield and why its rise impacts the Indian stock market.

US Debt Ceiling: Standoff should resolve sooner

The US 10-year bond yield refers to the interest rate paid by the US government on its 10-year Treasury bonds. When an investor purchases a US Treasury bond, they are lending money to the government for a specified period, in this case, 10 years. The bond yield is the annual return an investor can expect to receive as a percentage of the bond's face value.

For example, if the US 10-year bond yield is 3%, and an investor buys a $1,000 face value bond, they can expect to receive $30 per year in interest (3% of $1,000). The bond yield is a key indicator for investors and economists as it reflects the cost of borrowing for the US government and can influence broader interest rates in the economy. In financial markets, changes in the 10-year bond yield are closely watched because they can provide insights into the economic outlook.

Why is the US 10-year bond yield increasing?

The world has seen the US 10-year bond yield crossing the 5% mark during the 2008 financial crisis. To bring the number down, the US central bank cut the interest rate (or policy rate) brought it near zero, and then increased it marginally in later years. The 10-year yield was between 2% and 4% between 2009 and 2019 (10-year bond yield tracks interest rate). The interest rates were increased only in 2016 but were brought down again during the pandemic.

The central bank's and government's decision post the pandemic led to higher inflation - much higher than the US's comfort zone. The only option to bring the inflation numbers down was to increase the interest rate (or policy rates). With the ongoing Russia-Ukraine war and the newly started Gaza-Israel war, the Fed could not bring the inflation number down below its target level of 2%.

However, the central bank has recently said in public that it is committed to bringing the inflation number down to 2%. How will it achieve this? By increasing the policy rate further and the market expectation of it translated to a 10-year yield touching a 5% level.

To sum up, the US 10-year bond yield can rise for multiple reasons. Here are the top three reasons:

• Inflation Expectations: If investors expect higher future inflation, they may demand higher yields to compensate for the eroding purchasing power of money over time. Central bank policies and economic indicators, such as the Consumer Price Index (CPI), can influence inflation expectations.
• Central Bank Actions: The US Federal Reserve, the country's central bank, plays a significant role in influencing interest rates. If the Fed signals a tightening of monetary policy by raising short-term interest rates, it can lead to higher bond yields across various maturities, including the 10-year.
• Supply and Demand Dynamics: Changes in the supply and demand for bonds in the market can affect yields. If there is an increased supply of bonds or reduced demand, yields may rise to attract investors.

How rise in US 10-year bond yield impact the stock market?

You now know why the 10-year bond yield increased recently. But why did the Indian stock market fall because of it? In this section, we will explain the reason.

To understand, you need to answer this - would you prefer 8-9% guaranteed returns for 10 years or invest in the stock market where the returns are uncertain? Most investors would be tempted to go to 8-9% guaranteed returns, especially if they have already made good profit in the stock market in recent years.

But the US 10-year yield was at 5% and not 9%! 5% and 9% returns completely change the equation. See, 9% returns were taken for your (Indian) understanding. If you factor in the inflation (6%), the effective return is only 3%. In the US, we are talking about inflation going back to 2%, and with 5% returns on 10-year bond yield, the effective return for investors there is 3%, which is not bad at all.

So, when the US 10-year yield increased to 5%, there was a domino effect. US investors were expected to withdraw their money from the Indian market for this reason (they did as FII outflow suggests). Indian investors also sold for that reason, and we had a fall of 1,000 points in a week.

Future of the Indian market amid global tension

The domestic macroeconomic data pointers suggest that the Indian economy is stable. The inflation numbers in India are under control. However, most economies across the globe might show a slowdown. As a result, the stock market in India is likely to remain volatile as it also tracks global developments. The Indian economy is expected to be the fastest-growing economy but it would need global support.