Inverted Yield Curve and its significance

The short-term bonds are issued in maturities of 1, 2, 3 and 6 months while the Long term bonds with a maturity of 1, 2, 3, 5, 7, 10, 20 and 30 years. There are two main factors that determine the return on bonds: The fund rates that are provided by US Federal Reserve acts as the foundation of the yield curve. This rate is the rate which an investor would earn for lending to US Government for 1 night, that is of the bond with 1 day maturity. Expectations of Future is another crucial factor that determines the yield. Interestingly, only the rate of Treasury Bill with maturity of 1 day is fixed by Federal Reserve (Fund Rate) while all other rates are directly determined by the market.

Let us assume Fund Rate is at 2% that means an investor would earn 2% annualised interest on investment of $100 for a bond maturing overnight. As the period goes on increasing, investors demand more interest rate in return for lending load to US Government. Here the investors are assuming that there would be more investment opportunities in future that would be giving better returns than fund rate. So, a ten-year maturity bond will have more yield than a bond with 3 months maturity. This is called as Normal Yield Curve.

When investors are concerned about the future interest rates and are not sure about finding better opportunities in near future, tend to flock in to buy Treasury Bills with longer maturity. Due to the demand and supply mismatch, the interest rates for longer term bonds tend to fall. In extreme cases they fall below the short-term rates. The scenario where short term bond has higher yield compared to long term bonds has an Inverted Yield Curve.

Why are Yield Curves so Important?

Currently, the US Treasury Yield curve is flattening. That means, Short Term Yield of US Treasury is rising and the difference between Short Term Yield and Long-Term Yield is shrinking. In worst case scenario the Yield of Short-Term bonds may surpass the Yields of Long-Term bonds, an inverted Yield Curve may occur.

Historically, since World War II, whenever the US Treasury saw an inverted curve, there was a recession in following 6 to 18 months. So, Inverted Yield Curves are considered as a reliable indicator for an upcoming economic recession. For this purpose, bond rate of 10-year bond and 2-year bond are compared. If the spread is negative, it indicates an inverted yield curve.

From the table below, it is evident that the yields for 2-year Treasury have surpassed the yields for 10-year Treasury indicating an inverted yield curve. Not just that, there is an inversion even for 30-year Treasury. The curve has deepened more since the Fed announced a 75 bps hike in Fund Rate and with Fed intending to raise the rates further, the yield for 10-year Treasury may continue to slip downwards.

Global Recession

Global economies right now are under intense pressure of inflation. Central banks across the globe have scrambled to hike interest rates in order to contain the inflation. India till now, has been able to limit the inflationary trends compared to Western Countries, this leaves India with more room to accommodate growth and curtail inflation.

Federal Reserve has clearly indicated that the priority of the US government is to contain the inflation and they are willing to trade-off growth for the purpose. This has been so far the clearest signal from the Fed about a recession. The same is the case with many other western economies. US already has an inverted yield curve for a month now signalling a recession ahead.

Recession, Markets and India

Even though India is 5th Largest Economy, it is not interlinked with global economies like the US or the European economies are. Majority of Indian production is consumed internally and while India is a net importer of Energy, India has been successful in arming itself with a bazooka of Forex. Forex plays a significant role in limiting the widespread impact of Global Recession. Today, India is far better placed than it was in 2008.

Geopolitical events are a greater worry for markets, higher than anticipated US Fed hikes. India’s efforts in digital economy can become an asset for the nation in times to come. India has a National Infrastructure Bill which is yet to be in motion which can be India’s leverage if recession is to strike.

India’s stature as a peaceful and friendly nation can make it an attractive destination for companies that are looking to shift the supply chains out of China. If we compare Indian markets with that of US and Germany over all 2 years, we can see Indian markets have been performing very well indicating a strong sentiment in India.

Prospects of India skipping a recession are too high. India as a nation is well equipped to deal with a global shock. The domestic demand has been very good with companies having their order books filled for couple of quarters. A global recession may send the oil prices down which should help India in cooling down it’s inflation.

Thank you.

Regards,

Adwait Bhide,

Kautilya,

IBS Mumbai.