Bonds are at the cusp of a breakdown, will equity follow?

US treasuries (UST), a key benchmark for global interest rates, is on the cusp of a breakdown, which could lead to a further sell-off in the equity markets.

In our article published on 6 July, we had mentioned that a sell-off in UST threatens the equity rally and that's exactly what happened. Now treasury prices have dropped again to support, with an increased potential of a breakdown. The consequent rise in interest rates threatens the bumpy recovery in the economy which results in a fall in equity prices.

We say that there is an increased potential for bond prices to break support as that support level has been touched earlier. Support levels are areas where the demand exceeds supply, leading to a rally in price. The more times a support level is touched the weaker it gets. Let us look at the chart of 10- and 30-year US treasury prices to analyse the market.

 Bonds are at the cusp of a breakdown, will equity follow?

US treasury chart. Firstpost.

The upper chart shows the prices of 30-year USTs and the lower one shows the price action of 10-year treasuries, which are the more widely followed benchmark. The horizontal lines on both the charts show the support level. The white arrows show the number of times the support level as been touched. Now if the support level is breached UST prices could go all the way down to the level marked by the white ellipse. However, prices have to break before bears get confirmation of a further downtrend in both bonds and equities. Note that since prices are at support, there is also the likelihood of a rally, which will negate the bearish analysis. So wait for the break before turning more bearish.

Remember interest rates have a huge impact on stock markets. We believe that the markets can bear a rise in interest rates for sometime but not for long. For instance, between 2003 and 2007, interest rates were rising but so were the equity markets. But now even with a little rise in interest rates the equity market tends to fall. Normally there is a lag between the rise in interest rates and fall in the equity market. However, now the tight inverse correlation between equities and interest rates may show that we are in a new normal. It tells us that the economy has no capacity to bear a rise in the cost of money.

The global economy was goosed up by the Federal Reserve that printed money through its quantitative easing programme. The money found its way to the equity markets and also a lot of emerging economies. Now, as the Federal Reserve plans to reduce its quantitative easing, interest rates have risen, threatening the equity markets.

Sensex and Nifty: Let us look at the combined chart of the Sensex and Nifty

Sensex and Nifty charts.

Sensex and Nifty charts.

The chart on top is the Nifty and the one below is the Sensex. Notice that we have left the lines on the chart from two weeks ago. The Sensex, which held the red uptrend line, broke it on Friday. Nifty, on the other hand, was weaker than the Sensex and broke its uptrend line earlier. Nifty is now respecting the support shown by the green horizontal line. If Nifty breaks the support shown by the green line it can go all the way down to 5,250. Sensex will toe the line.

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Updated Date: Dec 21, 2014 03:16:59 IST