Does India's yield curve imply a slowdown?

Oct 15, 2011

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
In the last year, the Indian economy has witnessed periods of either inverted or flat yield curves. The yield curve is a plot of the return on government securities versus time to maturity. Most of the time, yield curves are upward sloping. Thus, government bonds that have longer maturities have higher interest rates. This makes logical sense, as higher interest rates reward putting away one's funds for a longer period of time.

The shape of the yield curve depends on two factors. First, long-term interest rates depend on future expected short-term interest rates. All else equal, if short term interest rates are expected to fall in the future, then current long term rates will be lower, and vice versa.

The second factor affecting the shape of the yield curve is the term premium. Long-term interest rates require investors putting away their funds for longer periods and at potentially greater risk, thus long-term securities command a term premium. The term premium makes long-term interest rates higher than short-term interest rates, all else equal.----------------------------- Don't Miss! Best of The Daily Reckoning... -----------------------------

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The combination of these two factors means that most of the time, the yield curve will be upward sloping. If short-term interest rates are not expected to change, the term premium will ensure an upward sloping yield curve. So when we see a flat or inverted yield curve, it means that short-term interest rates are expected to fall significantly. The fall is so much so that it outweighs the effect of the term premium.

What we can learn from India's yield curve over the last year is that the market expects short-term interest rates to decline significantly in the future. We can translate this into what we expect the Reserve Bank Of India (RBI) to do going forward. Currently, they are raising interest rates; however, the market expects that in the next few years they will be lowering interest rates.

It is often said that a flat or inverted yield curve is a sign of bad economic times to come. It implies that the economy will go into recession or will slowdown in the next few years. The reasoning for this is as follows: In general, when economic conditions are poor, central banks will lower interest rates in order to stimulate growth and investment. If interest rates are expected to fall significantly in the future, it means that central banks will be lowering interest rates in the future, presumably because the economy has slowed down.

Many empirical studies have confirmed the relationship between an inverted yield curve and a recession. The majority of the time, a recession or slowdown tends to follow an inverted yield curve. So the important question for us is whether the India's yield curve is a sign that an economic slowdown is likely. This is certainly one view. There are already signs that the economy is slowing down and the inverted and flat yield curves are further signs that this slowdown will continue. However, there is another reason why the yield curve can be inverted, and this is not due to a potential slowdown.

As we mentioned, a flat or inverted yield curve implies that the RBI will be lowering interest rates in the future. They could be doing this because the economy is slowing down. Alternatively, they may be lowering interest rates if inflation has come down. Just as they are currently raising interest rates to combat high inflation, they may lower rates in the future if inflation is falling and is low.

The (RBI) is an example of a hawkish central bank. This means that they tend to adjust interest rates more in response to inflation, rather than growth. This is evidenced now, as they continue to increase interest rates even though growth has fallen and the economy has witnessed some slowdown. This adds further weight to the idea that they will be lowering interest rates in the future due to lower inflation, rather than lower growth.

Thus, we can interpret flat and inverted yield curves in a pessimistic or an optimistic way. On the pessimistic side, it is a signal of lower growth and economic slowdown to come. On the optimistic side, it is a signal of lower inflation to come. We should also note that we might end up with a combination of both, that is lower growth as well as lower inflation. Either way, we can't conclude for sure that India's yield curve implies that a slowdown is definite.

One final point to keep in mind is that our interpretation of the yield curve tells us only what the market expects. The market is expecting lower short-term interest rates in the future, and this could be due to lower growth or lower inflation. Just because the market is expecting this, does not mean it will occur. We could just as well end up with higher short-term interest rates due to unforeseen events.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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6 Responses to "Does India's yield curve imply a slowdown?"


Oct 17, 2011

very nice lucid article, enjoyed reading it.
I would guess optimistic expectations on inflation and RBI action are playing a major role in keeping the curve flat. People remember the last bonds bull run where GoI bonds gave over 30% returns. The long end of the curve may well be overbought - the RBI's stance suggests that we might see a solid year or more of high rates - I don't think too many bond buyers are factoring that in.



Oct 17, 2011

Thanks for the refresher. Nice read.


Jarnail Singh Brar

Oct 17, 2011

Dear Sirs,

Why are you giving Asad Dossani's articles under the Daily reckoning by Bill Bonner? This is deception.



Jeevan Shetty

Oct 16, 2011

Very good article. Lucid explanation of the complex abstract concept in a simple manner so that whoever reads with some interest can grasp the idea about yield curves.


vijay barve

Oct 16, 2011

it is foolish to blame rbi . growth for whom. commodities real estate food everything is in bubble territory more speculative than real investment. in poor country inflation hurts ordinary person and needs to be controlled. thanks.


Jagadeshwer Rao

Oct 16, 2011

Nice explanation!!

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