Inversion of US treasury yield

Subject: Economy

Context:

The US does look headed for a recession — a key pointer is the inversion of US treasury yields.

Concept:

Recession:

A recession typically involves the overall output in an economy contracting for at least two consecutive quarters, along with job losses and reduction in overall demand.
The US National Bureau of Economic Research (NBER) decides whether the economy is in a recession based on its assessment of the depth, diffusion, and duration of the impact on the economy.

Government Bonds

In any economy, the safest loans are those that are given to governments, typically do not default on their debt.
The instrument by which the government borrows from the market is called a government bond.
- Example- In India they are called G-secs, in the UK they are called gilts, and in the US, they are called treasuries.

Bond yield:

A government bond comes with a pre-determined coupon payment/Rate of interest.
- Example- The government may “float” a 10-year bond with a face value of $100 and coupon payment of $5. This means, if one lends $100 to the government by buying this bond, he/she would get $5 each year for the next 10 years plus the whole sum of $100 at the end of 10 years. This would imply a yield of 5%.
But since the bonds are traded in the secondary market–one can sell this bond to another investor, the yield will change depending on the price at which the bond is sold.
If the price increases — say, the bond is sold for $110 — the yield will fall because the annual return ($5) remains the same. And if the price falls, the yield will rise.

The yield curve and recession:

The yield curve is the graphical representation of yields from bonds (with an equal credit rating) over different time horizons.
- Example– if one was to take the US government bonds of different tenures and plot them according to the yields they provide, one would get the yield curve.
Types of yield curve:
- Under normal circumstances, any economy would have an upward sloping yield curve. Meaning-as one buys bonds of longer tenure — one gets higher yields.
- Bond yield curve becomes inverted when bonds with a tenure of 2 years end up paying out higher yields than bonds with a 10 year tenure.Such an inversion of the yield curve essentially suggests that investors expect future growth to be weak.
  - When investors suspect that the economy is heading for trouble, they pull out money from short-term risky assets (such as stock markets) and put them in long-term bonds. This causes the prices of the long-term bonds to rise and their yields to fall (bond prices and bond yields are inversely related).
  - This process first leads to flattening and eventually the inversion of the yield curve.

How bond yield inversion predicts recession?

Inversion of the bond yield curve has become a strong predictor of recessions.
In the current instance, the US Fed has been raising short-term interest rates, which further increase the short-end of the yield curve while dampening economic activity.

Impact on India:

Rising interest rates are likely to make the US dollar even more strong against the rupee.
Indian imports will become costlier as a result, and could fuel domestic inflation.
Higher returns in the US may also lead to reduction in the capital inflows coming to India.
Indian exports may benefit due to a weaker rupee but a recession will dampen the demand for Indian exports.
A slowdown or recession may lower crude oil prices for India.