Near-inverted yield curve shows RBI almost at end of rate cycle

Near-inverted yield curve shows RBI almost at end of rate cycle

The government securities (G-sec) yield curve inverted momentarily last week, leading some pundits to paint doomsday scenarios for India’s economic growth. Leading strategist Richard Bernstein, formerly of Merrill Lynch, recently said that there were “monstrous risks" in emerging markets, pointing to inverted yield curves in Brazil and India. Spread between India’s 10-year and one-year debt shrunk to around 10 basis points on Tuesday, against a 2.5 percentage point difference a year ago. One basis point is one-hundredth of a percentage point.

An inverted yield curve is supposed to predict a recession or, at least, a dramatic economic slowdown and a reversal in earnings momentum of firms as lower long-term yields indicate investors are nervous about growth prospects. This is especially true in the US treasuries market, where studies have shown that inverted yield curves are harbingers of recession. Locally, however, it is erroneous to draw a similar conclusion.

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Unlike in the developed markets, the bond markets in India are segmented. Banks are the single largest participants in this market because of mandatory norms that require them to hold a significant portion of deposits in government bonds. Therefore, the G-sec yield curve is not an evolved signalling mechanism as it is in developed markets.

The shorter end of the yield curve has spiked up only because of rate hike expectations and tight liquidity. Indeed, liquidity has been tight for about a year, and bond dealers point out that a spate of cash management bills from April and increased treasury-bill supply will lead to higher yields.

In any case, as Standard Chartered Bank’s India economist Samiran Chakraborty said in a recent note: “In a country like India, where the services sector dominates GDP and the rural economy generates substantial output, the relationship between interest rates and the real economy might not be very strong. In addition, the supply pattern of government bonds (linked to fiscal deficit), which has little bearing on GDP growth dynamics, is often the dominant factor in the GoISec yield curve."

What does history tell us? In the past eight years, the G-sec yield curve inverted just once: between June-October 2008. At that time, the repo rate was hovering around 9%, and bonds started falling ahead of rate cuts by the Reserve Bank of India (RBI). There was no recession, despite what happened in the rest of the world, although economic growth did slip to 7-8%.

In the current context, note that bank deposit rates are hovering around 10%. Deposit and credit are still growing at double-digit rates. Note also that recent advance tax growth came in at 19%, which further negates a doomsday picture.

To sum up, while the local inverted yield curve points directionally to a slowdown, what it probably means is that the bond markets are signalling that RBI is near the end of its tightening cycle.

Graphic by Yogesh Kumar/Mint

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