Where will markets be without central banks?

Bond markets have become quiescent for the time being, beguiled or bludgeoned by the actions and words of the central banks.

By Sanjeev Prasad, Anindya Bhowmik & Sunita Baldawa

All data points suggest a strong global economic recovery in general and in the US, in particular All economic estimates and indicators point to a strong recovery in the global economy over the next 1-2 years. In particular, the US economy is likely to grow strongly based on current concurrent and leading indicators, Europe will see gradual recovery and China is anyway doing well. The Indian economy will also recover through FY2022-23E.

Tapering and higher bond yields is a matter of time
We would assume that central banks will have to ‘taper’ their bond buyback programs in the not-too-distant future. We see two realistic scenarios for the US economy over the next 9-12 months (this applies to other countries too)—(1) strong economic growth and high but transient inflation, the current consensus view shaped by the US Fed and (2) strong economic growth and high and structural inflation, which will result in faster ‘tapering’ and rate increases.

Central banks will have to reduce their bond purchases in either scenario. Bond markets have become quiescent for the time being, beguiled or bludgeoned by the actions and words of the central banks.

Taper but not necessarily tantrum

In our view, markets will be fine as long as the yield gap (earnings yield less bond yield) was to stay at reasonable levels. In the specific case of the Indian market, the current yield gap is reasonable by historical standards. Two things could go wrong—(1) earnings downgrades and (2) sharp increase in bond yields from current ‘suppressed’ levels (due to bond purchases by the RBI). A moderate increase in bond yields is manageable as higher bond yields will be offset by higher ‘roll-forward’ earnings; earnings yield will also rise if the market was to stay around current levels. We expect 30% growth for FY2022 (built in 12-month forward earnings yield) and 14.5% for FY2023 in net profits of the Nifty-50 Index.

Where would yields & markets be without central banks?
This is not an easy question to answer given the abnormality associated with ‘infinite’ bond purchases by central banks and the ‘infinite’ nature of their ballooning balance sheets. Suffice to say, their actions have suppressed bond yields, which was anyway the key objective of their QE programs. In the Indian context, the 12-month forward P/E varies a lot based on different ‘input’ bond yields (50, 100 and 150 bps higher) or cost of equity in other words. Another way to look at this issue is to compute a theoretical policy rate based on certain input parameters for FY2023, which would give an indication of the extent of increase in policy rates and bond yields over the next 12-15 months.

Authors are with Kotak Institutional Equities

Edited excerpts from Kotak
Institutional Equities’ India Daily
report dated June 14