In today’s Finshots, we explain what’s up with the bond markets and the yield curve.
First, we need to tell you what on earth is a yield curve.
Think about it this way. The government needs to borrow money from us to fund its various expenses, right? And when it wants to borrow money, it issues something called a bond. This is a more formalized IOU certificate. It’s a promise that the government will repay what it borrows. And tack on some interest for our troubles.
Now, these bonds come with all kinds of maturities. The government could issue a 1-year bond to mop up money to pay pensions to its former employees. It could issue a 5-year bond to invest in healthcare facilities. It could borrow for 10 years to fund a massive infrastructure project such as an expressway. Anything.
Typically, the longer the borrowing tenure, the higher the interest rate it has to pay.
The logic is simple — there’s a lot of uncertainty associated with a long-term loan. You don’t know what could happen in the next 10 or 20 years. Governments could change. The world economy could collapse due to a financial crisis. Even war could erupt. And in order to compensate for all this uncertainty, as a prudent investor, you ask for a higher interest rate from the government. You might lend the government money at 7% for 1 year. But you ask for 9% when it’s for 10 years.
Now if you’re a visual person, you want to see all this on a graph. So you take the interest rates on all these bonds — with maturities of 1, 3, 5, 10, 20 years — and plot them on a piece of paper. You join these dots together and you get a squiggly line.
That, folks, is the yield curve. And in a normal world, this line gently slopes upwards. Because as we said, “the longer the borrowing, the higher the interest rate.”
But here’s the thing now. The yield curve in India did something freaky a couple of days ago. It inverted. It turned upside down. It sloped downwards.
When the government tried to borrow for 1 year, people demanded to be paid 7.48% (the interest or the yield). On the other hand, a 10-year bond was giving 7.47%. And as per Reuters, the last time something like this happened was way back in May 2015.
Now this doesn’t seem like a big deal. It’s a minor difference. It’s more like the yield curve is flat. It’s a not-so-inverted yield curve. But if you ignore the semantics and think about it, it means people are fine with earning less on a long-term loan. They’re not asking for a premium for all the uncertainty.
And if you translate that into plain old English — people are betting that the near future will be worse than the future far away.
See, people could be asking for more money today because they think that inflation is going to remain high. And if that’s the case, the central bank could increase interest rates quickly to combat it. But when interest rates rise, it quells demand. It pinches the appetite for borrowing money. People might spend less. And that’s a bad thing for economic growth.
That’s why people fear an inverted yield curve. They think it’s a bad omen.
But while that all sounds good in theory, we have to be practical and ask the most important question–Does it really portend an economic slowdown in real life?
Well, it’s hard to say for sure. But we could look at research from the past.
Here’s what a couple of researchers found when they looked at Indian data between 2005 and 2018. They checked to see if the yield curve could predict a slowdown in quarterly GDP (after stripping out the agricultural component) and saw that it got it right a whopping 90% of the time!
And the thing is, this yield curve inversion has struck the US too. In a big way. The difference between the short-term bond yield and the long-term is at its highest level since 1981! And over the past five decades, an inverted yield curve is almost always followed by a recession within a year or so.
Seems like quite an ominous sign, doesn’t it?
So that’s the bad news. But maybe. Just maybe, some folks think the freaky yield curve could actually be good news.
How, you ask?
Okay. Let’s say that investors believe we’ll suffer from high inflation in the near future. And that the inflation will be 7%. So they ask for a higher interest rate from the government bond now. Say 7.50%. This way, they can make at least 0.50% worth of real money.
But these investors also believe this high inflation is an anomaly. They think that inflation will quickly cool to the Reserve Bank of India’s (RBI) target of 4%. And that the central bank won’t even have to raise interest rates by much to crush demand and inflation. So it won’t have a bearing on economic growth. So they’re quite content with a 7% interest rate for a long-term bond. They know the big picture is the sweet 3% real return they’ll make.
And if you think about this example in ‘real’ terms, that means the yield curve is sloping upwards. It’s 0.50% in the short term and 3% in the long term.
Maybe that’s what’s happening now. Investors are expecting things to simply go back to normal quickly without too much drama from the RBI. And the yield curve is not really forecasting an economic slowdown.
Anyway, we don’t know if this is just a feel-good theory to make ourselves feel better about a potential economic downturn. Or whether the not-quite-inverted yield curve is actually sounding us a real warning as it mostly does.
Only time will tell.
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