Dow outperformance over Nifty is accounted for by yield curves
The last one year has seen the US markets handsomely outperform the Indian markets. Dow Jones Industrial Average (DJIA) has returned 16% over the last one year as of 31st of July 2011 while the Nifty has returned just 2% over the same period. There are a lot of explanations of the outperformance of the Dow over the Nifty and yield curves are definitely one of them.
In July last year, the US treasury yield curve was steep i.e. upward sloping with the spread between the ten year US treasury and the two year US treasury at over 300bps. The Indian government bond yield curve too was upward sloping, but not very steep with the spread between the ten year bond and the two year bond at around 40bps.
The yield curves in July 2011, tell you the story of why the Nifty has underperformed the Dow by a wide margin. The Indian government bond yield curve has flattened considerably with the spread between the ten year and two year government bond down to 5bps. The US yield curve too has flattened with the spread between the ten year and two year treasury at 270bps. However, the US yield curve is still steep compared to the Indian government bond yield curve which has flattened out fully.
The US Federal Reserve (Fed) maintained loose monetary policy throughout last year by keeping policy rates at close to zero percent levels and by printing money to buy US treasuries. The US equity markets rose on the back of Fed’s policies. The US Fed is still maintaining a loose monetary policy, though it has stopped treasury purchases. The yield curve has flattened out due to worries on the US economy, as the US is committed to spending cuts of over USD 2 trillion over a period of time.
The RBI on the other hand has tightened policy rates considerably since July 2010. Repo rates have been raised by 250bps over the last one year in order to ward off inflationary pressures. Inflation has remained sticky at 9.5% levels over the last one year and RBI has had to raise policy rates to bring down inflation expectations. The RBI’s actions have resulted in the government bond yield curve flattening out completely over the last one year. The high inflation and rising interest rates have taken its toll on the Nifty and it has returned a very poor 2% over the last one year.
The yield curves are telling a story. The flat yield curve in India is indicating that inflation and growth will come off down the line. The Nifty is corroborating the fact with its underperformance. The steep yield curve in the US is reflecting the low rates in the economy, which is expected to give a boost to growth. However the recent fall in ten year treasury yields from levels of 3.5% to 2.9% since April 2011, is reflecting a potential slowdown in the US economy.
Going forward it is essential for the Nifty that yield curves steepen. A steepening yield curve will mean that RBI is through with rate hikes and growth can pick up. Until then the Nifty will continue to languish for a while, as rates remain high in the economy.