381-point Dow surge disappears as bond jitters return

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The Dow has dropped more than 1,000 points on Thursday, primarily because of concerns about the bond market and inflation.

"The conversation about equity risk premium, interest rates and inflation, we are coming full circle". With stock prices at near all-time high levels, if one seeks a "risk premium" of say 6 per cent, at prevailing bond yield of 7.56 per cent, the stocks need to give 13.56 per cent returns; which does not look feasible. Wage inflation means core consumer price inflation index could well rise well above 2.5 per cent by this summer and force the new Fed Chairman Jay Powell to respond to prove that the U.S. central bank is not behind the inflation curve. The move was its biggest one-day reversal since February 2016. USA government bonds, meanwhile, are considered virtually free of risk of default. U.S. Treasury bond yields have been so low that many stock dividends are paying better.

The sharp increase in bond yields in India over the past few weeks has been attributed to investors' concerns about the fiscal slippage in FY18 and a higher-than-expected fiscal deficit target for FY19.

The yield on the 10-year Treasury bond ticked higher again on Thursday morning, to 2.88%. "Now they are saying we will take out the steroids, because it could have side-effects", said Nilesh Shah, MD at Kotak AMC.

Low interest rates have made risk assets more attractive for years, and a change in that environment is creating a shakeout in stock valuations.

USA 10-year Treasuries dropped, pushing the yield to a four-year high, as United Kingdom gilts sold off.

"You could get into a little bit of circular logic here, as you hand leadership back and forth".

"There's going to be an interplay, a bit of push and pull between the rates market and equity market", said Mark Cabana, head of US short rate strategy at Bank of America Merrill Lynch. European markets raced higher, while stocks in Asia were mixed.

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"The normal crisis relationship between equities and bonds was restored yesterday", Deutsche Bank strategist Jim Reid said in a note.

"I think there's going to be an interplay between equities and rates probably for the next several months, until we get greater clarity on how the overall growth outlook is going to be and if the Fed is thinking about shifting the reaction function", said Mark Cabana, head of USA short rates at Bank of America Merrill Lynch.

Bond yields across the bloc fell 5 to 6 basis points, after rising to multi-year highs in recent sessions on expectations strong growth and a pick-up in inflation would encourage central banks to pull away from ultra-easy monetary policies. At the same time, the US deficit is growing and would be bumped up even more by the Senate budget deal, if it passes Congress.

"If there is going to be a recession, it will be next year, not this year, but there could be a slowdown in the U.S. economy as inflation is picking up, which could lead to stagflation in Q2 and Q3", he said.

Since that post, treasury yields have rallied as bonds have slipped.

Furthermore, in Europe five-year German bund yields moved into positive territory for the first time since November 2015. "There is no doubt interest rates will rise and liquidity will be withdrawn but it will be gradual and calibrated in nature", said Shah of Kotak Mutual Fund. The ECB [European Central Bank] cut their quantitative easing in half.

Kotak Institutional Equities in a recent note suggested that the market was overlooking the rising yield on some "misguided view" about earnings and macro-economic factors being less relevant to the equity market against ample global liquidity. "The Fed's kind of this wild card because it could really pump the brakes pretty hard and cause the cost of borrowing to go up and really cause the economy to stall".

Fed speakers will get a lot of attention Thursday. "When that ball bounces out, it's going to spike", said Boockvar. Dallas Fed President Robert Kaplan speaks at 4:50 a.m. ET in Frankfurt, Germany.

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