Yield Curve Inversion

Subject : Economy

Section: Fiscal Policy

Concept :

Bond yield

Bond yield is the amount of return an investor realizes on a bond. Required yield refers to the amount of yield a bond issuer must offer to attract investors.
The money that investors earn is called yield.
Investors do not have to hold bonds to maturity. Instead, they may sell them for a higher or lower price to other investors, and if an investor makes money on the sale of a bond, that is also part of its yield.

Yield Curve

A yield curve is a graphical presentation of the term structure of interest rates, the relationship between short-term and long-term bond yields. It is plotted with bond yield on the vertical axis and the years to maturity on the horizontal axis.
The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity.
A yield curve tells us about the relative cost of short-term and long-term debt.

Inverted yield curve

An inverted yield curve is just opposite of the normal yield curve (therefore, it is also called abnormal yield curve).
When the yield for shorter maturities is higher than the yield for longer maturities, the yield curve slopes downward and the graph looks inverted.
An inverted yield curve is unusual; it reflects bond investors’ expectations for a decline in longer-term interest rates, typically associated with recessions.
As evident by the blue curve in the chart above, it occurred in 2000 during the dot com bubble.

Normal yield curve

In general, long-term yields are typically higher than short-term yield due to the higher risk involved in long-term investment. Since this is the most common shape of the yield curve, it is called the normal yield curve.
The short-term yields are heavily influenced by central banks such as US Federal Reserve and the long-term yields are a function of the expected short-term interest rates in future and the market’s assessment of the inherent risk.
Normal yield curve typically exist when an economy is neither in a recession nor there is any major risk of overheating.
The normal shape of the yield curve is upward sloping, i.e. short term yields (yields of short term bonds) are lower than long term yields.

How did Indian G-sec yields invert recently?

The G-sec yield curve became inverted at the Friday weekly auction last week against the similar phenomenon in the US. and RBI accepting banks’ demand for higher yield at the auction for the medium-term G-Sec.
But there was good demand for the longer-term G-Sec from insurance companies and provident funds at a relatively lower yield.
At the last auction, the cut-off yield of the 2036 paper came in at 7.4527 per cent, while that of the 2062 paper came in at 7.3822 per cent. So, the yield curve became inverted.

What does it imply?

Experts say yield curve inversion could denote an impending economic recession or slowdown.
However, this phenomenon may be short-lived once the demand for medium papers from banks increases.
Currently, banks are demanding higher yields for medium-term G-Secs as a hedge against the likelihood of the rate-setting panel going in for a rate hike at its next meeting to tackle the sticky core inflation. However, after a year or so, the expectation is that there could be rate cuts to support the economy.
Twenty-nine countries, including the US, Canada, Germany, Singapore and France, have a ‘ totally inverted yield curve’.

What steps is RBI taking to correct the curve?

The central bank will try to ensure that the yield curve slopes upwards as the tenor of G-Secs increases.
Due to banks’ risk aversion for medium-term G-Secs, RBI, in consultation with the government, announced a revised calendar for March for the auction of Government of India Treasury Bills, increasing the demand for these securities.
The government will be borrowing ₹1.95-lakh crore next month via T-Bills against ₹1.45-lakh crore notified in the earlier calendar.