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Is India's yield curve inverted?

Jun 22, 2011

In our previous article we discussed the basics of yield curves. In this article, we aim to understand the nature of yield curves in India currently. We will also try and understand a little bit about inverted yield curves.

If you recently opened a newspaper, or even visited the grocery store you would have noticed one thing. The price of everything seems to be going in one direction, up! Inflation has hit the economy hard. To battle this monster, the central bank has been aggressively using its monetary tools. Just last week, the RBI raised its key policy rates once again, making this the tenth rate hike since March 2010. The repo rate (rate at which RBI lends to banks) now stands at 7.5%, an increase of 2.75%. Through these moves, the RBI hopes that it can curb demand, reduce credit growth and thus control inflation.

But, what impact are the RBI's moves having on government bond yields? Has India's yield curve inverted?

Inverted yield curves

According to Investopedia: "An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields." It is also called as a negative yield curve. In this case there is a negative relationship between yields and time to maturity.

Why is this indicator so ominous? Just as dark clouds hovering in the sky indicate that rain is on the horizon, an inverted yield curves is a strong indicator of a recession. An inversion of the yield curve preceded six out of America's last seven recessions over the past four decades. When short term rates are higher than long term rates, the outlook for the future is typically bleak. So, with its latest rate hike, has the RBI forced the country into a recession?

India's G-Sec yield curve

Well, we cannot say that the current yield curve in India is completely inverted. Rather, it exhibits some form of partial inversion. This, according to Investopedia "is when only some of the short-term treasury papers(5 or 10 years) have higher yields than the 30-year treasury papers do."

Source: Bloomberg, Reuters

Between the 6 month and 1 year rates we can see some inversion. This means that if the govt. had to borrow for 6 months, it could have to pay a higher yield than what it would pay if it had to borrow for 1 year. The short end of the yield curve is higher as a consequence of RBI's hawkish stance and ongoing rate hikes We can also see that the Indian yield curve is flattish, since there is not much difference between the 1 year and ten year rates, as can be seen in the chart above. As per the current data the difference is around 0.12%. Even if the government had to borrow for 30 years, yields would be around the 8.6%, while for 3 months it is at 8.1%.

Our emerging market peers are also in similar situations. Brazil has hiked its key interest rate four times this year to 12.25%, since it is also facing the heat of inflation. China's yield curve is also relatively flat, with a less than 1% difference between 1 year and ten year yields.

The flattening of India's yield curve, beyond the one year mark shows that interest rates may moderate in the future, and the battle against inflation may be won. But, economic growth may also see some moderation as a consequence.

One can also see a slight kink, at the 10 year mark where the yields are lower than at other maturities. Does this also show inversion? Well, since, ten year government bonds are highly liquid, they command a higher price, and thus lower yields. This is due to inverse relationship between bond prices and yields.

So will inflation win the battle or will growth moderate due to the rate hikes? In our final article in this series we will focus on the impact these yield curves, and how they affect companies, banks, and benchmark indices.


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1 Responses to "Is India's yield curve inverted?"

pradeep

Jun 23, 2011

I no economist, however for a growth economy is this not natural. As the country grows, we should expect the interest rates and inflation to fall (if we can manage debt), in which case we should expect long term yields to be lower than short term ones as they are bumped up by imported inflation

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