Historically it is an indication that recession is looming large. The Centre has come up with many stimulus packages to stem the slowdown but whether they will save the economy from a downturn or not is anybody’s guess
Data analysis suggests that historically an inverted yield curve has been a precursor to an economic slowdown. So, there are fears that the economy might enter into a recession in the next few quarters.
We have to look at the possibility of a massive crisis in the world economy in the backdrop of unprecedented technological disruptions worldwide, global trade wars and the shift away from fossil fuels.
But first, let’s look at what an inverted yield curve is and why is it so important?
Bonds or Debt instruments that are listed on the stock exchanges get traded by buyers and sellers. At any point in time, a bond would carry a yield or a likely rate of interest or return that an investor is likely to generate if the bond is held till maturity.
However, the yield keeps changing based on the prevalent interest rate scenario, prospects for economic growth, tenure of the debt, credit ratings and inflation.
A yield curve is a plot or graphical representation of the yields of bonds growing across maturities — say from three months to 30 years. All listed bonds issued by Governments across the world, corporates and financial institutions carry certain yields.
Usually, bonds with a longer tenure carry higher interest rates as compared to ones that are issued for shorter time frames. The idea is that the later the redemption or gratification of the bond, the higher should be the interest offered to the investor.
In many western countries and even some major Asian nations, the yields on long-term bonds are lower than those for shorter tenure debt instruments. Therefore, the yields curve now would be ‘inverted’.
So why is the yield curve inverting?
Much of the blame has been put on the US-China trade war. When it started over two years ago, there was hope it would get resolved as both sides kept the talks going. But a deal hasn’t come through even as US President Donald Trump has put off the latest round of tariffs on Chinese imports (video games, smart phones, laptops, toys) to December 15.
The delay affects about half of the $300 billion target list of Chinese goods. However, tariffs on tools, apparel and some footwear took effect on September 1. Trump apparently backed off his September 1 deadline for ten per cent tariffs on remaining Chinese imports, in the hopes of blunting their impact on US holiday sales.
But the trade tiff between the two largest economies of the world is creating uncertainty and investors are rushing to buy US bonds, largely considered a safe haven.
However, the problems besetting the Indian economy are different. Its financial sector is grappling with trillions of rupees in bad debt and resolution of most cases is still slow. Fear of probe agencies over fresh bad debts and a liquidity crunch are hampering lending by banks. Even as the world talks about negative interest rates, India continues to see high interest rates and the country is still the second-fastest growing large economy of the world.
So the question arises, why negative yields and interest rates?
Investors are willing to buy bonds at any price to protect themselves against sell-offs in other risky assets in case the fear of a recession materialises. The rise in bond prices pushes yields downward. Holding cash can be an alternative. But that too may not work, as in the case of many western countries.
Indian bonds remained volatile over the past year or two on uncertainties over the maiden offshore sovereign bonds issuance. India’s benchmark ten-year bond yield fell below 6.40 per cent (in the previous year it was 6.48 per cent) after Finance Minister Nirmala Sitharaman assured that the offshore bond issuance plan was on track. The Reserve Bank of India (RBI) board met in mid-August to discuss the issuance plan.
Foreign Portfolio Investors (FPIs) shifted from equities to debt in August-September as FPIs turned net sellers in equities for the first time since January. Tax proposals outlined in the Budget, including higher tax incidence on FPIs and high-net-worth individuals (HNWIs), in addition to levy on buybacks, dampened and punctured some of the optimism in the equity markets.
Global cues are under watch even as the US Federal Reserve on October 30th approved the expected 25-basis point (BPS) interest rate cut, though it indicated that the moves to ease policy could be nearing a pause. Meanwhile, cash conditions are in surplus of Rs 1 trillion and are likely to stay so ahead of the advance tax payments.
The inversion in the bond yield is an indication that recession is coming. But somewhere we need to be cognisant of the fact that commodity prices have remained low for a long time and if global liquidity moves into soft commodities, which have been slightly benign, all the assumptions of Indian recession will go. The Central Government is trying its best to tackle the economic slowdown. They have come up with a stimulus package for the beleaguered automobile sector, they have announced mergers of banks, corporate tax cuts and so on but will this much save the Indian economy from a recession or will the slowdown continue further? The answer lies in the future and all we can do is wait and watch.
(The writer is an author and GST and economics specialist)