Correlated markets: Bond market signals downward valuation, end of bull run at KSE

Correlation between bond, stock market hints stocks tend to be bearish when bond prices go down.


Kazim Alam July 30, 2013
The stock market has been at record-high levels with the KSE-100 Index up by roughly 13% in July. This has happened despite the fact that bond prices and stocks have traditionally been correlated. PHOTO: FILE

KARACHI:


Minor corrections notwithstanding, the long bull run of the Karachi Stock Exchange (KSE) is spectacular in every sense of the word. But how long is the sun going to shine for investors to continue making hay is a question that market observers have already begun to ask.


And the signals of an oncoming downward revision of stock valuations are coming from a not-so-likely place: the bond market.

Students and practitioners of finance know well how interconnected the stock and bond markets are. After accounting for what analysts call “response lags”, historical trends show that these markets tend to move in a typical order: a general rise in the cost of goods leads to inflation, which paves the way for an uptick in the interest rates in the economy. As interest rates are inversely proportional to bond prices, the latter start declining while the former go up.

With declining bond prices, their current yield tends to increase sharply. And that’s exactly the way the bond market in Pakistan has reacted in the past few weeks. The yield of 10-year Pakistan Investment Bonds (PIB) has increased rapidly by 90 basis points to 11.8% in July alone, according to a research note written by Farrukh Khan of KASB Securities, a Karachi-based brokerage house.

On the other hand, the stock market has been at record-high levels with the KSE-100 Index up by roughly 13% in July. This has happened despite the fact that bond prices and stocks have traditionally been correlated. Historical data shows stocks tend to be bearish when bond prices go down. After all, companies are likely to underperform, as borrowing becomes expensive for them and the cost of doing business increases on the back of high inflation.

So what does the bond market’s reaction suggest? According to Khan, it shows its fast-changing inflation expectations mainly because of a likely hike in power and gas tariffs along with devaluation and possible monetary tightening under the IMF programme.

“Although the bond market is giving clear signals that it believes a reversal in the course of monetary policy is imminent, and that the current discount rate is unsustainable, equity valuations are not pricing in that risk yet,” he said, while hinting at a negative impact of between 3% and 8% in the valuations of the listed companies that are on the radar of KASB Securities.

Currently, the yield differential between the 10-year PIBs and the 12-month treasury bills is at an eight-year high of 283 basis points, which is in stark contrast with an average differential of 98 basis points for the last five years.

Explaining the significance of this unusual gap between the yields of 10-year PIBs and treasury bills, Khan said the risk-free rate will have to be revised up by at least 100 basis points in case the PIB yield sustains at the current level. “Using the discount rate or 10-year PIB rate as the risk-free rate will now yield very different valuations (of the listed companies). This has not been the case in the past, as the average yield differential has been less than 1%,” he noted, adding that the inflation trajectory will determine the course of monetary policy.

Published in The Express Tribune, July 31st, 2013.

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COMMENTS (1)

MA | 7 years ago | Reply

to all so-called small investors, who keep losing their shirts: first half of this article is akin to icing on a cake. traders should be spending more time studying markets and inter-market relationships than trading.

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