A first since 2007: Sensex's yield gap with 10-yr US bond turns negative

The benchmark BSE Sensex closed with a weekly loss of 2.7 per cent this Friday, its biggest seven-day loss in more than a year.

Prior to this, the index’s worst performance was during the week ended June 17, 2022, when it closed with a weekly loss of 5.4 per cent.

The decline in the broader market was led by a sell-off by foreign portfolio investors.

With their sell-offs on Friday, foreign portfolio investors (FPIs) have turned net sellers in September after being buyers for six consecutive months.

FPIs have now cumulatively sold Indian equities worth $1.53 billion, compared to cumulative net investments worth $20.94 billion during March-August this year.

More than half of the net sell-offs by the FPIs occurred in the last four trading sessions of the current week. The equity market was closed on Tuesday on account of Ganesh Chaturthi.

One of the triggers for the sell-off by FPIs has been a sharp decline in the spread between the earnings yield on Indian equities and yield on US treasury bonds.

The spread, which indicates the additional potential yield that foreign investors in Indian equities earn over the risk-free US treasury, has now slipped into negative territory for the first time since December 2007. This is due to a sharp rise in bond yields in the US in recent months.

A zero or a negative spread was last seen in the last quarter of 2007, on the eve of the big crash in stock prices in January 2008 (See the adjoining chart).

Spread between the Sensex earnings yield and US 10-year government bond yield has now declined to -0.36 per cent, the lowest since October 2007.

It is also down sharply from a spread of 0.67 per cent a year ago.

Historically, the spread between earning yields and the US benchmark treasury bond has mostly been in positive territory (see the adjoining chart).

The Sensex had an earnings yield of 4.11 per cent on Friday against 4.47 per cent yield on 10-year US government bonds. The bond yield in the US is up 65 basis points (bps) in the last 12 months compared to 38 bps decline in the Sensex earnings yield during the period.

A stock or index earnings yield is inverse to its trailing 12-month price-to-earnings multiple. It is a hypothetical dividend yield for an investor if the company / index distributes 100 per cent of its annual profits as equity dividends.

Lower a stock price-to-earnings multiple, higher is its earnings yield and vice versa.

Higher earning yields mean a greater arbitrage for investors over investment in risk-free financial instruments such as government bonds and bank fixed deposits.

The spread between Sensex earnings yield and US 10-year government bonds is crucial as the rally on Dalal Street is largely driven by inflow from FPIs.

Indian markets rise when the FPI inflow is strong and it falls when FPIs sell and withdraw their money.

The sharp decline in spread is due to a persistently-low earnings yield of Indian equity. This is despite a steady rise in the yield on US treasury bonds, which acts as a benchmark for pricing risky assets all over the world.

The Sensex earnings yield is up 86 bps in the last two years from 3.25 per cent at the end of September 2021. During the same period, the yield on 10-year US government bonds is up by 298 bps from 1.49 per cent at the end of September 2021 to 4.47 per cent on Friday.

This has made the Indian equity market less attractive to foreign investors.

“The price-to-earnings (P/E) multiple on the Indian equity market is nearly 46 per cent higher than the average P/E multiple of 26 major global markets. This is now driving weakness in Indian equities as the hardening of bond yields has lowered the spread potential returns from India and global risk-free yield,” said Dhananjay Sinha, head research and equity strategy at Systematix Institutional Equity.

Many analysts now see a further rise in US treasury yields after the US Federal Reserve hinted at the possibility of keeping interest rates higher for longer to fight inflation in the country. This is likely to weigh on the prices of risky assets such as emerging market equities, including India.