The gap between what investors earn on short-term and long-term bonds has narrowed considerably since May 2006, the Reserve Bank of India has said in the third quarter review of its monetary policy.
The gap between the yields on one-year and 20-year bonds fell from 158 basis points at the end of April 2006 to 86 basis points on 25 January 2007.
The gap between the yields on one-year and 10-year bonds is now a wafer thin 59 basis points, down from 118 basis points in April 2006. (A basis point is a hundreth of a percentage point.)
This is a puzzle, since the difference among bond yields on various maturities usually widens when inflation is rising, as it has in India.
Headline inflation has climbed from 3.6% to 6.1% between 29 April 2006 and 11 November 2006. In December, short bonds actually had higher yields than long bonds—or what economists call an inverted yield curve.
That is an early-warning sign of a coming recession. The inversion of the US-yield curve in 2006 raised concern about a recession in 2007.
Economists say that while the flat yield curve is a bearish signal in advanced economies, it is not a matter of great economic significance in India.
“The current shape of the yield curve is an anomaly,” said Shuchita Mehta, an economist with Standard Chartered Bank.
Others say that the yield curve has artificially flattened because banks have churned their bond portfolios in recent months, even as they sold bonds to fund credit growth in excess of 25%.
That such a churning of portfolios can create a yield curve that defies economic logic suggests that the Indian bond markets have not yet evolved.
They are still too shallow and prone to speculative pressures, said a bank treasurer.
While the narrowing gap between short and long bonds is not a recessionary signal, some economists say that it points to another problem.
“The structure of the yield curve shows that risks are being mispriced,” said Rupa Rege-Nitsure, chief economist at Bank of Baroda. And that should be a cause for worry.