Markets on tenterhooks as inflation fears surface

Trajectory would hinge on Street’s perceived inflation forecasts

The markets are expected to remain volatile because a spike in US bond yields is likely to trigger a flight to safety among investors.

Last week, the yield on the 10-year US Treasury rose to as much as 1.61 per cent, which sent shockwaves through global equity markets. The Sensex and the Nifty plunged nearly 4 per cent on Friday.

What could give comfort to investors is that the US yields have cooled to 1.41 per cent, although they still remain high, compared with 1.08 per cent a month ago.

Also, the House passing US President Joe Biden’s $1.9-trillion Covid relief bill could cheer investors. The bill includes a $1,400-cheque, unemployment benefits, and funds for state and local governments to revive growth.

The Dow Jones on Friday fell 1.5 per cent, but the technology-heavy Nasdaq came off its lows to end with a gain of 0.56 per cent. Experts said the market trajectory would hinge on the Street’s perceived inflation forecasts. While policymakers don’t see inflation as a big risk, last week’s bond market movements suggest that a spike in inflation is on the horizon.

It remains to be seen if the inflation surge will be temporary due to stimulus spending or stickier, which could prompt central banks to raise interest rates, said experts.

“Bond market investors are sitting on the edge of the seat and are set to rush for the door at the first hint of an interest rate rise. Any signs of hardening interest rates could see more money move out of equity markets into higheryielding bond markets. We can expect some dovish comments from the Federal Reserve and other central banks to soothe investor nerves. If they can talk down concerns about interest rates, there is a chance that markets can stabilise,” said U R Bhat, director, Dalton Capital Advisors (India).

On Friday, foreign portfolio investors (FPIS) dumped Indian equities worth ~8,300 crore ($1.1 billion), triggering the biggest single-day fall in the rupee of 104 paise in nearly 19 months. The rupee closed at 73.47 to the dollar. Experts say if FPIS continue to take money out of domestic markets, the rupee could weaken, which could lead to further turbulence.

The India VIX index, a volatility expectations indicator, on Friday spiked 23 per cent to 28 — a reading last seen during July 2020, when Covid uncertainties had plagued the market. The benchmark indices have almost doubled from the pandemic lows in March 2020. This rally has been underpinned by low interest rates in the US. Between April and December, the yield on the 10year US treasury has averaged 0.73 per cent.

“If employment starts to increase as economies begin to recover and people spend, it will stoke inflation. And interest rates could rise quicker than we thought. And if investors get the same yield in bonds, they might move out of equities. I don’t believe central banks will turn around if the economy gets overheated. They say now we are worried about inflation and, therefore, will increase rates quicker than expected. That will spook everyone,” said Andrew Holland, chief executive officer, Avendus Capital Alternate Strategies.

After last week’s correction, the Sensex and the Nifty have come off 6 per cent from their all-time highs of 52,154 and 15,315, respectively. At the current level of 49,100 and 14,529, the Sensex and the Nifty still trade at 20x their estimated earnings for 2022-23. This is higher than the 10-year average of about 16x. Experts say the valuation could revert towards the mean if market conditions turn challenging.