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For now, there is no telling how long the ongoing rout in the bond market will continue. As bond prices kept sliding, yields have risen by 50-60 basis points in less than two months.

On the other hand, the benchmark Sensex and Nifty indices have risen by around 1.5 percent each over the same period. In fact, as on Thursday, which was the day of expiry of December futures and options contracts, the Nifty had gained 2.5 percent since the expiry of the last series.

Rising bond yields seem to be telling a story, one of risks to fiscal deficit and inflation. The equity market, on the other hand, has a story of its own–one of a pickup in earnings in 2018 and steady inflows into equities. And the confusion seems to be about whom to believe.

If the bond market is factoring in a risk to inflation, equities should ideally reflect it since inflation is bad for equity investors. Rising inflation gives makes a case for hiking rates, which would in turn increase companies cost of borrowing. Higher inflation would also mean companies would be spending more on raw material. But the equity market seems to be ignoring this completely, because it is factoring in a possible uptick in earnings in the coming few quarters.

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However, if the current rise in bond yields is due to risk of fiscal slippage rather than a harbinger of inflation, the current trends make more sense. A big worry for equity investors is that the government may cut back on spending to meet fiscal deficit target. By borrowing more, the government may have send out a signal that growth matters more than sticking to the fiscal deficit target. And some of the money will eventually trickle down to some companies in some form or the other.

I think bond yields are reacting to the risk of fiscal slippage at the moment, not risk to inflation, said an economist with a private sector bank who wished to remain unnamed. Inflation is a point of concern, yes, but assuming that the RBI will hike rates more proactively just because of that would be wrong. It would have to assess the inflation trajectory, juxtapose it with the growth trajectory, and then take a call.

Another factor pointed out by experts that could explain the dichotomy between the bond market and the equity market is that inflation is coming off a low base. The deflationary pressures faced by some of the developed economies in 2015-16, which spread to India late last year and stayed well into this year, are now easing. So even if bond markets are worried about rising inflation, corporates not seeing it the same way. Economic growth is a function of both real growth and inflation and unless they shoot up drastically, higher prices can be passed on to the consumer and translate into more profits for a company.

Also, earnings of companies are expected to improve in the Jan-March and April-June quarters, particularly because of last years low base, which was on account of demonetisation and the roll-out of GST. The tax rates have been rationalised and compliance is increasing with each passing quarter, which leaves room for further rationalisation in the future.

There is a slightly different way in which equities and bonds are reacting to inflation right now, said R Sivakumar, Head of Fixed Income at Axis Mutual Fund. But I dont think the bond market is factoring in an inflationary spiral of sorts because we are not expecting a sustained rise in inflation, just an easing of the deflationary pressures we saw around a year ago.

Sivakumar also pointed out that prevalent bond yields are more reflective of a risk of fiscal slippage rather than an uptick in inflation. RBI is expected to maintain a hawkish stance on policy for some time now but whether or not inflation will worsen to an extent where RBI is forced to increase rates is yet uncertain, he said.

The 10-year benchmark bond yield is currently trading at 7.37 percent, 2 basis points lower than its previous close, after having risen 18 basis points in Thursdays session. Bond yields and prices move in opposite directions.

Meanwhile, the benchmark Nifty and Sensex indices were trading at 10,522.05 and 34,018.75, 0.4 percent and 0.5 percent higher than their previous closing levels.

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