Yield curve inverts in the US and flattens in India, hinting at slowdown

Hints at possibility of recession or a big decline in economic growth

As investors and the bond market brace for a sharp hike in policy rate by central banks to fight inflation, the yield curve has inverted in the US. It has begun to flatten in India, hinting at the possibility of recession or a big decline in economic growth globally and in the domestic economy.

Yield curve inverts when short-term yields are higher than long-term yields. In the US, the yield on short-maturity bonds, such as three- and five-year government bonds, is now higher than the yield on long-tenure paper, such as 10- and 30-year bonds.

The yield on three-year US treasury shot up to 3.45 per cent on Wednesday, from 0.96 per cent at the end of December 2021. In the same period, the yield on 10-year treasury bonds increased to 3.36 per cent, from 1.51 per cent.

As a result, the yield spread between the two declined to a negative 9 basis points (bps), from 55 bps at the end of the last calendar year. The spread was as high as 139 bps in March 2021 at the peak of the post-Covid boom in economic growth and the equity markets.

1 bps is one-hundredth of a per cent.

In India, the yield spread between 10-year Government of India bond and two-year government bond declined to a 28-month low of 94 bps. The spread was 185 bps at the end of March this year before the Reserve Bank of India (RBI) began raising interest rates, and the peak spread of nearly 200 bps in July last year. Similarly, the yield spread between 30-year and 10-year bonds crashed to 27 bps on Wednesday, down from a high of 93 bps in June last year.

This has resulted in a flattening of the zero-coupon yield curve as the yield on shorter-tenure papers has risen faster than those on long-tenure bonds - 10-year or higher.

“In the normal course, the yield curve should be steep with interest area or yield rising with the rise in tenure. But it has now flattened as the RBI has begun to tighten monetary policy, leading to a decline of liquidity in the financial markets,” says Devendra Pant, chief economist, India Ratings & Research.

He expects the yield spread between long-term and short-term bonds to remain low as long as the RBI maintains a hawkish monetary policy, but rules out an inverted yield curve in India.

The yield curve had last inverted in India in September 2015, coinciding with a sell-off in the equity market in the second half of 2015. 

The yield curve had also inverted in the May-August 2013 at the height of the taper tantrum. Even worse, the yield on the two-year treasury was 80 bps higher than the yield on the 10-year paper. This has coincided with sharp depreciation in the rupee and big sell-off on Dalal Street.

Other economists attribute the flattening to the yield curve management by the RBI.

“The yield on 10-year bonds is far lower than what it should have been if the markets were left to themselves. The RBI is very sensitive to 10-year yields and tries its best to keep it anchored,” says Madan Sabnavis, chief economist, Bank of Baroda.

But he says the recent movement in the yield curve follows deterioration in the economic outlook of most major economies, including India.

“The inversion of the yield curve in the US has increased the probability of an economic recession. If the yield on a three-month paper rises to 3 per cent, which is possible if the US Federal Reserve raises rates, then recession in the US is a given,” says Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity.

The yield on three-month US government bonds is now at 1.8 per cent - up sharply from 0.18 per cent at the end of January this year.

Analysts say a sharper rise in yields on short-tenure paper also means most firms are only borrowing short, and reluctant to make long-term investment, given the elevated levels of uncertainty in the economy. This is another downside risk to economic growth.