Mumbai: Rising inflation and tight liquidity are casting a wider shadow over the government bond market. In a rare phenomenon that usually points to an economic downturn and tightening credit, yields on long-term Indian government bonds have fallen below those on short-term debt.
The so-called inversion of the yield curve, or slope of rates in the government bond market, has preceded US recessions in the past. The US treasury yield curve got inverted in 2000 just before US equity markets collapsed. Theoretically, an inverted yield curve signals extraordinary market conditions. A “normal” yield curve shows interest rates for long-term instruments being higher than the rates for shorter-term paper. There are also times when the yield curve is “flat”, which means there’s little difference in short- versus long-term rates.
“The inverted yield curve may mean recession for developed countries but, in India, it means a moderate deceleration in growth,” said Mohan Shenoi, head of treasury at Kotak Mahindra Bank Ltd.
The yield curve inverted for a brief period in mid-2007 when the short-term market stabilization bonds flooded the Indian market to soak up excess liquidity caused by huge dollar flows into the economy.
“In the present context, the negative yield curve simply means that liquidity is tight,” says Agam Gupta, head of treasury at Standard Chartered Bank. Brokerage firm First Global Securities Ltd, in its latest report on the bond market, warned that the current yield curve sends signals of “uncertainty about the future economic direction. The yields on short-term five-year bonds will increase further amid a credit crunch in the economy as the bond prices fall.”
“As of now it appears that 10-year bonds are considered relatively safer investments as investors believe that conditions will stabilize in the long term. Thus, the demand for 10-year bonds will increase and their prices will rise, thereby leading to a decline in their yields,” the report added.
The inverted yield curve also indicates that rising inflation, driven by a surge in oil, commodity and metal prices, is reducing the attractiveness of government debt, particularly short term, according to First Global.
India’s economic growth is expected to moderate this year from its annual 9% pace with the rise in interest rates and tightness in liquidity following a series of policy measures by the country’s banking regulator to rein in the 13-year high inflation. The Reserve Bank of India (RBI) this year raised its key short-term lending rate by 75 basis points and banks’ cash reserve ratio, or the cash banks have to maintain with the Indian central bank as a proportion of their deposits, by 125 basis points. One basis point is one-hundredth of a percentage point. RBI made money costlier to combat inflation, causing rates in the interbank call money market, where banks borrow to tide over their temporary asset-liability mismatches, to rise above 9%.
Apart from tight liquidity, bond traders also blame demand-supply mismatches for the inversion of the yield curve which some say could be a temporary phenomenon.
“If we see the trading in bonds, we would find only the 10-year security is liquid,” said Arun Kaul, chief general manager and former treasury head of Punjab National Bank. “In securities of other maturities, there is hardly any trade happening.
“So the 10-year bond is volatile while the rest are largely static. I won’t call it an inverted yield curve. This is just a temporary aberration,” he said. “The reason could be as elementary as availability of securities to trade.”