Inverted Yield Curve and its impact

Inverted Yield Curve and its impact

In the last article Understanding the Yield Curve we understood the basics of the yield curve; let’s focus more on the current situation wherein the G-sec yield curve in India has inverted significantly.

Yield Curve is a leading indicator of the economy & a good predictor of future economic activity.

Steep Yield Curve i.e. Positive spread between shorter and longer duration papers is generally followed by period of stronger growth and lower volatility, whereas inverted yield curve, where the yield on shorter duration papers is higher than longer ones, is followed by poor growth and recession.

The Inverted Yield curve predicts a recession or rather a slowdown in the economy with a reversal in earnings momentum of firms as lower long term yields indicate a loss of confidence.

Since 1960 in the US, a yield curve inversion (as measured by the difference between ten year and three month Treasury notes) has preceded every recession on record.

Some Analysts feel that an Inverted Yield curve is a classic recessionary signal in advanced economies but they don’t necessarily signal the same in the emerging economies.

In the emerging economies both ends of the yield curve operate on completely different drivers. The shorter ends of the curve are taking cues from the monetary policy and the longer end is primarily driven by the capital inflows into the country and the appetite for emerging market debt among the international investing community.

Since 2000 in India the yield curve has inversed for two times before July 2013 and interestingly they have lasted for brief periods only.

Inversion spread

Inversion spread21

The macro economic conditions in India are different this time because of the depreciating currency. The long term yields have gone up considerably to attract and retain foreign in-flows but the stabilisation of the currency is the key.

Amid falling INR, the RBI is facing a heightened challenge of impossible trinity ‐ in a scenario of relatively free capital mobility; RBI’s attempt to stabilize the exchange rate is restricting its freedom to set the monetary policy. This policy trilemma will continue until the exchange rate stabilises and uptil, the monetary policy making will remain constrained by external considerations.

To sum up, we feel prolonged slowdown in the Indian economy seems inevitable under current circumstances.

References :

http://www.newyorkfed.org/research/capital_markets/ycfaq.pdf

http://www.newyorkfed.org/research/current_issues/ci2-7.pdf

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