Off late, there has been a whole lot of discussion around the Yield Curve, especially with the recent inversion of the US Treasury Yield Curve - a phenomena commonly deemed to be a “Recession Predictor” of sorts. It is rather fascinating to analyse how a small change in the Yield Curve is representative of the upcoming possibilities in a country’s economy. The article attempts to analyse the Indian Bond Yield Curve, since 1998, highlighting its key aspects and how the Indian economy has reacted to any change in the curve and vice-versa.
First things first. How to interpret the chart.
We have the weekly Bond yields of available India Government Bond maturities since Jan 1998 till 17th March 2019.
Instances where the yield points are not connected in the chart suggest the unavailability of a yield point of an intermediate maturity. Over time, the Indian government issued bonds of varying maturities, and hence one can see the curve dancing to its full potential in the later years.
Pretty neat, isn’t it!
The gif illustrates how India's Yield Curve has changed over the course of time, but what does it really represent? Before we get into that, here is a recap of some of the common traits of a Bond Yield Curve.
a. Normal Yield Curve
b. Inverted Yield Curve
c. Flattened Yield Curve
d. Steep Yield Curve.
We shall now move on to examine how the Yield Curve has changed over the course of time.
Due to the lack of enough data points, it is rather difficult to interpret anything substantial during this phase. Noteworthy however, is the fact that both the short term and long interest rates were above 10% during this period.
There is an overall downward shift in both the short term and long term bond yields throughout this period. What caused the downward shift and what does it imply?
The short term rates fell from 6% to 5% - quite a significant drop. A Central Bank usually announces a rate cut to boost the economy, and/or to avoid recession. As borrowing money becomes cheaper, consumer spending tends to go up, thus further increasing the money circulation in the economy.
In recent times, we have seen countries such as Japan/EU set the interest rates below 0% - a rather severe measure, nonetheless helps revive the economy. A similar effect was felt in the Indian economy as well. India GDP growth rate shot from 3.8% to a staggering 8%.
One wonders...if low interest rates are good for the economy, shouldn’t they be just kept low? Not really.
When rates are low, borrowing becomes cheap, which means debt market shoots up, increasing the overall debt in the economy. This is what happened until 2004. 2005 onwards, until the dawn of the financial crisis, rates kept increasing, indicative of a highly distressed economy.
During this period, short term rates shot up more than the long term rates indicating efforts by Central Banks to prevent inflation, which of course, was the Financial Crisis of 2008. Long term rates are not driven by the Central Bank policies. They provide an overall view of the economy on a longer term horizon. During these times, the spending decreases, and savings increase, implying trouble in the short term.
So, now we know that something bad with economy is about to happen. Too late now, though!
This chart is quite interesting. I have split it in 3 sections, all of which are equally important. It highlights the period leading to the crisis, the actions/measures taken during crisis, and the slow recovery thereon.
The period until August 2008...Well, by now, the crisis had almost hit the United States, and it had its repercussions felt globally. Short term rates (6months/1 year), all shot up vis-a-vis the long term rates. A classic case of Yield Curve flattening. There is a recession in sighting!
Then it struck! A sharp decline in the Bond yields. Money became cheap again - a drastic measure taken by Central Banks across to handle the crisis. A good measure indeed! Short term rates fell from as high as 9% to just below 5% within a couple of months. That is extreme! Short term rates kept falling, highlighting the Steepening of the Yield Curve. This was done to encourage consumers to borrow more and kick start the economy. Across the globe, Central Banks took significant measures to inject more money into the economy - US reduced interest rates, EU initiated the Quantitative Easing program et al.
Over the course of the next 3 years, the Indian economy tried to recover. Slowly and gradually, rates increased indicating an overall revival. Yield Curve returned to its normal shape, not flat, not steep and definitely not inverted!
The recovery happened, or so it seemed. After returning to its normal shape, India Bond Yield Curve went on to become flatter. Short term rates again shot up to coincide with long term rates.
From the Financial crisis, it became quite evident that a crisis is not just limited to the economy in which it is started. This time around, with rising commodity prices, and looming Euro debt crisis, the RBI had to increase short term interest rates over and over again, hence leading to the Flattening of the curve again.
The Curve remained similar until mid 2013, when suddenly an inversion happened - 6 months bond yield shot up to 11%, while the 10 year Bond yielded only 9%. An extremely rare scenario! It was a desperate and deliberate attempt by the RBI to defend the weak Indian Rupee, thereby making it hard for speculators to sell currency. As Reuters summarised,
The RBI’s strategy of using short-term money markets to defend the rupee seemed ideal. By anchoring long-term yields, the Central Bank could ensure that its policies to defend the currency were contained at the short end of the Yield Curve and so did not affect other borrowers and investors in the economy.
Indeed, a very drastic measure taken by the RBI.
Returning Back to Normalcy (2014 - 2016)
It took some time for the Yield Curve to change its course. It remained inverted until 2015, but there was a gradual decline in the interest rates across maturities. Across the globe, emerging markets economies continued to struggle. With rise in commodity prices, and oil reaching new highs, emerging market economies tumbled up until 2015. Emerging market currencies weakened against the USD. Yield Curves remained flat or inverted (in India’s case).
But beginning 2016, the Indian economy began to recover its lost sheen. Both long term and short term yields fell, with short term falling more than the long term. The Yield Curve had started to return to its normal phase, some of which could be attributed to oil prices, as it took a significant hit in the global markets. Highly depended on oil and a major importer, the Indian economy fluctuated with the rise and fall of oil prices.
So, what’s happening these days? What can we read from the current Yield Curve? From 2017 until mid 2018, rates were increasing constantly - a sign of rising debts, heavy corporate books, banking books.
As we now know of the Black Friday and the Flash Crash of September, it became evident that there was a bubble in the Indian economy, waiting to burst. In September 2018, a financial crisis in Indian Housing Sector emerged, and it extended itself to other parts of economy as well. With much at stake, and the 2019 General elections in the offing, the Central bank had to constantly lower rates to make room for cheaper borrowings. Short term rates have gone down significantly compared to long term rates, highlighting the Steepness in the Yield Curve again. This allows for cheap short term financing, further raking up the overall debt in the economy.
With the upcoming General Elections, it is highly unlikely that the interest rates will change much. As highlighted above, long term yields are generally an indicator of the economy in the longer run. In this regard, the Yield Curve is likely to become Normal again with long term rates falling faster than short term rates on back of a slowing GDP growth.
Originally Published here.
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