Here's how global debt market volatility will decide equity market trend

Indian investors were too busy mourning over their losses in the equity market sell-off to notice that they missed the ‘short of a lifetime’. Bond king and legendary bond trader Bill Gross of Janus Capital said last week that the bond markets were offering a ‘short of a lifetime’. Warren Buffett also commented that bonds were ‘very overvalued’.

As if waiting for a cue, European bonds fluctuated the most since the eurozone debt crisis. The correction was long overdue as bond yields were in the negative territory. Reports say that investors were buying EMU (Economic and Monetary Union) sovereign debt late last year and early 2015, with German Bunds being the favourite. Demand for German Bunds was so high that German yields dropped below zero for maturities even eight year away.

The number of global bonds trading with negative yields has plummeted in the past fortnight. In the space of three weeks, the amount of bonds trading with negative yields has dropped from $3 trillion to $1.7 trillion in a sign that borrowing costs may have hit the floor, according to JPMorgan research. With yields so low, real investors shied away from the bond markets. Lack of liquidity also compounded the problem of sharp volatility in the bond market.

But the worst is not yet over. HSBC in a report say that pressure on bond yields could return in the next few weeks. The fall in bond prices has coincided with a rise in net supply of eurozone bonds which is due to fall back in June and July. The resulting squeeze could fuel a further rally in the market, says the HSBC report.

Volatility in the European bond market coincided with Federal Reserves’ Janet Yellen’s statement that interest rates in the US would probably rise in the next six months. Investor interest in emerging markets seems to waning. Data compiled by NN Investment Partners (NNIP) showed that emerging markets suffered some of their largest outflows in the past three quarters than during the financial crisis, soaring to $600.1 billion over the nine months running to March. The high levels of outflows from emerging economies have rarely been seen before, notably around the time of the Lehman collapse and the Asian crisis of the late nineties. For India, the issue of MAT on FIIs further compounded the problem.

Rising bond market yields are a cause of worry for emerging markets. Morgan Stanley said that the Fed’s most recent dovish tilt “allowed emerging markets some breathing space again”. Manoj Pradhan, an economist at the US bank, said vulnerable economies had failed to take advantage of the reprieve offered by the central bank. “As a result, for the second time in three years, we have an emerging markets rally that has little fundamental support,” he warned.

As was the case during the QE tapering, markets were jittery every time the Fed talked about cutting down liquidity. Jose Vinals, IMF capital markets chief (Read here), warned last month of a brewing “super Taper Tantrum”. If the Fed starts to raise its rates, emerging markets could face a rout worse than that of 2013, as Treasury yields and the dollar spike in unison.

Bank of International Settlements data showed that international investors increased their emerging markets holdings by nearly 87 per cent from 2008 to 2012 to over $8 trillion, as they took advantage of low US borrowing costs. That’s a lot of money which would be leaving the emerging market shores. The current fall in the market was due to withdrawal of around 10 per cent of that amount. Debt markets will first signal where the money is headed.