I had expressed concern over the risk posed by a flat yield curve in our Feb. 3 market outlook. Thankfully, we don’t have such a condition now. We now have a normal yield curve due to a decline in one-year treasury yields and a simultaneous rise in ten-year bond yields: the one-year treasury and ten-year bond yields are 7.069 per cent and 7.224 per cent respectively. But liquidity still seems tight with the overnight rate running at 6.65 per cent in the money market.
Regarding the current market condition, three things stay on top of my mind: 1) the rapid rise in gold prices over the last two months; 2) the rising US 10-year treasury yield; 3) the historically low value of India’s volatility index for the past year or so.
Let us consider them, one by one, starting with the ‘rapid rise in gold prices.’
Gold Price Spike
The 15 per cent rise in gold prices from 1 Mar. 2024 onwards seems bizarre. In 2023 – a good year for gold prices – prices rose 16.6 per cent for the full year. Over the last two decades, gold prices have compounded at 11 per cent. So, when compared to these figures, the 15 per cent gain in two months (Mar. and Apr. 2024) is surely bizarre. The international gold prices rose at the same pace from $2,043 per ounce at the end of Feb. 2024 to $2,318 per ounce now. Citi Research forecasts gold prices to reach $3,000 per ounce towards the end of 2024.
Reasons attributed to the price rise include the rising West Asia tension, central bank purchases, and an economic slowdown and easing of interest rates expected this year. Although India and China share the dais for being the world’s top gold consumers, when it comes to gold purchases this year and last year, China dominates. They have been on a buying spree for 17 straight months now.
The Chinese are flocking to safer assets due to limited investment options, escalating domestic economic troubles such as protracted property crisis, volatile stock market, and weakening yuan. Since gold tops the list of safe assets, the Chinese find them as a store of value under these extremely uncertain times.
The consensus expectation is for gold prices to continue rising. I discussed a contrarian perspective on gold prices in our March 2024 outlook. Despite that outlook entirely discussed gold prices, I discuss it again here, because of a visceral feeling that there is more to the recent gold price spike than generally thought. These writings are attempts to make an instructive sense of those visceral feelings… and I deeply hope that something meaningful and useful comes out of them…
It isn’t rising gold prices that concern me – they have been rising for a long time now. What concerns me is the steep rise in gold prices in the last two months: the 16 per cent gain almost equals the full-year gains for 2023. Attributing it to central bank purchases doesn’t make complete sense because central banks have been eagerly purchasing gold for the past two or more years. The cause of this year’s spike is something more than that… maybe a sign of something ominous…
The US Federal Reserve increased its policy interest rate at the steepest pace in 2022 and 2023 – from almost zero to 5.25 per cent. As interest rates rise, the cost of holding gold (opportunity cost) increases; therefore, gold prices are expected to underperform in such situations. But this time it didn’t… On the contrary, it rose at a rate higher than it historically rose. However, it isn’t the first time this has happened.
Two such anomalous events spring to mind. Gold prices rose after the Fed rate hikes of 2000 but were shortly followed by the dot com crash and the severe recession of 2001-2003. Similarly, gold prices rose after the rate hikes of 2006 but were followed by a market crash in 2008 that commenced the global financial crisis of 2008-2009.
The Indian equity markets are at an all-time high. The US equity markets made an all-time high in March 2024 – but have corrected 4 per cent since then. Anyway, the prevailing market sentiment is broadly optimistic. But this rampant optimism alongside the gold price spike only exacerbates my concern regarding the market’s near-term prospects. Many of the past major economic shocks were preceded by record-high market prices and excessive optimism.
If my feelings are right… the financial markets will face some serious troubles in the near term… but what those troubles would be… and from where those troubles would emanate from… such things are hard-to-impossible to know beforehand. But there is no wrong in trying… and that is what I am going to do… for the rest of this outlook…
Rising US 10-year yield
The 10-year US treasury yield, after peaking at 4.98 per cent in the middle of Oct. 2023, declined for the next two-and-a-half months and bottomed at 3.79 per cent by the end of Dec. 2023. The Fed rate cuts expected to happen soon likely caused the fall in yields. However, when the expectation about the timing of the first rate cut moved forward and the extent of rate cuts for 2024 got shortened, investor sentiments dampened, causing yields to rise – and has been rising so far this year – and now stands at 4.70 per cent.
In March 2024, although the Fed kept rates unchanged, markets cheered as the Fed reiterated its intention to cut rates three times this year: yields had dropped then. But the drop didn’t sustain. After a brief break, the rising trend of yields continued.
Rising bond yields are significant from a market perspective, particularly the US 10-year bond yields. The US yields have risen 75 basis points this year, while India’s 10-year bond yields have remained unchanged. This has made our bonds less attractive relative to US bonds.
Our bonds have been getting relatively unappealing for the past decade. Ten years ago, the spread between the US 10-year treasury and India 10-year bond was 600 basis points. Five years ago, the spread narrowed to 500 basis points. The spread is a significant factor in determining capital inflows/outflows into our country. A higher spread makes our bonds more attractive and attracts global capital into our country. As the spread declines, the attractiveness also declines, triggering capital outflow at some point.
Now the spread at 250 basis points is the lowest in recent history. The prime reason for the narrowing of the spread is the steepest pace of rate hikes by the US Fed in 2021 and 2022. Though not exactly alike, a narrow spread of 250 – 350 basis points prevailed in 2006-2007 consequent to Fed rate hikes then. The then narrow spread was corrected by the global financial crisis of 2008-2009. So, the last time it ended terribly.
The Fed is expected to cut rates this year. If so, we shall see a more gradual and normal correction of the yield spread without any ravaging impact on the markets and the economy. However, even though the Fed intends to cut rates this year, it is restrained from acting out those intentions by the stubbornly high inflation. In 2021, when inflation started rising worryingly, all major central banks, the Fed particularly, trivialised the inflation spike as transient. But they were wrong; they soon realised it wasn’t transient. But with that realisation also came another realisation – they have waited too long to act.
Their waiting exacerbated the inflation trouble and, unfortunately, to tame it, steep rate hikes not seen in 40 years were required. Then they waited too long to raise rates, and now, maybe they are waiting too long to cut rates. And what would its consequence be on the market and economy? I don’t know… maybe an economic downturn… people will suffer… and the suffering will be harsher for the vulnerable ones.
Who are the vulnerable ones? Generally, they are those with poor job security, those with mortgages, renters, and highly indebted ones – credit card loans, student loans, auto loans, other personal loans, etc… those with no savings, or very low savings rates…
And why are they vulnerable? When there is an economic downturn, firms downsize, and the vulnerable class are more likely to be victims of downsizing. Alongside, if they don’t have sufficient savings, then the hardship from the misfortune would be harsher: a disaster if they are heavily indebted too.
The US GDP in Q1 2024 at 1.6 per cent is the slowest growth in two years. Does this latest data indicate the arrival of the long-anticipated soft landing? Or is it a precursor to a hard landing? But what could be inferred from a single quarter’s performance?
Nothing… if we try too much… we might be able to decode… some good-looking but misleading nonsense… then cherish arrogantly our clairvoyance… until reality proves it completely wrong… but when proven wrong, rather than accept our mistake and learn from it… we skilfully gaslight it: This isn’t what I meant when I said that? It was misinterpreted… What I meant then was this… Blah! Blah! Blah!
India VIX is so low
India VIX declined 19 per cent last week. There was a single-day drop of 19.70 per cent on 23 Apr. 2024 – the steepest fall for the volatility index in a year. The median India VIX was 15.922, 22.212, 17.357, and 19.043 for the years 2019, 2020, 2021, and 2022, respectively. Comparatively, the prevailing 1-year median figure of 11.888 is relatively low.
There is so much calmness and certainty in the market among market participants – that is what the past year’s India VIX figures are conveying. Why shouldn’t it be? Over the past decade, the Indian stock market has declined in only one year – in 2015, that too a small decline of 4.06 per cent. For six of the past ten years, the gains were in double digits. The top gains were in 2014, 2017, and 2021, when the Nifty50 gained 31.39 per cent, 28.65 per cent, and 24.12 per cent respectively. Over the past five years, there were only two monthly declines greater than five per cent. Meanwhile, there were ten monthly gains of more than five per cent.
But could this calmness of the market for the past year or so be ‘the calm before the storm’ – a period of unusual stability that seems to presage difficult times?
Early this year, warnings from SEBI, the Indian market regulator, about the excessive fund flow into smallcap stocks and their expensive valuation, caused a slight turmoil in the midcap and smallcap space. Between 8 Feb. 2024 and 20 Mar. 2024, Nifty-Smallcap-100 declined by 13.35 per cent and Nifty-Midcap-100 by 7.30 per cent. However, the fall was short-lived, and now one-and-a-half months later, both indices more than recovered from the fall, and now trades at new all-time highs.
It is a common occurrence found during asset bubbles that warnings from authorities about froth in the system cause a pause in the price rally. But usually, such pauses are only temporary, and soon the rally resumes. A similar pattern was evident in what transpired within the midcap and smallcap space since February 8, 2024.
Does that mean we are in a bubble? There are signs or facts for and against the argument, but the final verdict is inconclusive. It always is… until the bubble bursts. Only when the bubble bursts and the freefall begins do we all agree that – yes! there was a bubble and we all fuelled it, knowingly or unknowingly. Until then everyone prefers the illusion of prosperity projected within the bubble and keeps dancing to its tune so long as the music goes on.
Usually, it is an event that pops an asset bubble and brings an end to the price rally. The event shatters, at least mildly, investors’ confidence in the sustainability of the price rally, and pushes them to question their unrealistic expectations that fuelled the price rally. The ensuing distress first causes prices to stop rising, and later to decline. The distress may escalate into panic, and if so, it triggers a freefall in prices.
Do we have a possibility for such an event now? The escalation of the West Asia crisis into a full-blown war in the Middle East; troubles in US commercial real estate causing a banking crisis; China is already in big economic troubles and those troubles percolating into the global economy; inflation, which many consider anchored, rising again; are a few possibilities that I could think of.
Through more time and thought perhaps I could come up with more possibilities. But there is no point in it – such efforts are futile. Because even if we distil out many such possible scenarios, however large that be, the actual event will most likely strike us… from the most unexpected of sources… in the most unexpected of ways… at the most surprising of times… and none of our preparations are going to safeguard us from the emerging onslaught fully…
Anyway, let me give it one more shot. The problem is too high an expectation that took root and flourished by too much optimism and certainty that prevailed for long periods. This is an election year, not just in India, but globally, the most important being the ‘US Presidential Election’ to be held in Nov. 2024. So that could be a ripe source for the disruptive event we are discussing here.
In India, the National Democratic Alliance (NDA), led by the Bharatiya Janata Party (BJP) under the leadership of Shri. Narendra Modi has been in power for a decade. In the ongoing parliamentary election, the expectation of NDA returning to power is almost one hundred per cent – the only question is by what majority? Opinion polls suggest NDA will win an average of 385 seats. The PM’s expectation is higher than that – 405 seats.
Business Standard recently noted a Bernstein Research Report that suggested the possibility of a market correction after the results of the 2024 Lok Sabha elections are out. “Somewhere in this noise of news studio debates, we seem to be losing track of ground realities in many states”, said the report, as per Business Standard.
So, even if the NDA returns to power, but with a much lower majority than expected, then the election results have every possibility to be a catalyst that pops an asset bubble.
But are we sure that there is an asset bubble in our equity market? Ah! Here we go again…
I look for ambiguity when I’m writing because life is ambiguous – Keith Richards
AMN CAPITAL 
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