Over the past few weeks, the economy of India has been in focus because of various factors such as decline in INR, slowdown in industrial image001production, etc. We keep reading a lot of articles that suggest that the policies of current government are responsible for this state of affairs.

A.Seshan in Businessline points to this known but seldom reported trend ongoing in India – inverted yield curve in G-sec markets:

A typical yield curve should be upward sloping indicating that the higher returns/rates/yields should be provided for taking higher risks which are generally over the long term. Similarly, lower returns/rates/yields should be for lower risks which are generally short term. In short, longer the time frame, higher should be the rate/yield that you should earn.

There is no reference in the two documents of the RBI to the recent performance of gilts in the market. There is an inverted yield curve prevailing now.

What does it signify? Ben Bernanke said in his address to the Economic Club of New York on March 20, 2006: “Indeed, historically, the slope of the yield curve has tended to decline significantly in advance of recessions.” Does it hold good for India?

The future yield is a function of the expected spot rate and the term premium, either of which could go up or down separately or together. The talented RBI researchers should come out with their interpretation of the current yield trends of gilts in the forthcoming Annual Report of the Bank.

Annual report comes out in August, so till then one has to wait.

In US, inverted yield curveis a very strong predictor of recession. Cleveland Fed in its monthly publication regularly predicts probability of recession based on yield curve. They show inverted yield curves have predicted most recessions in past. Even in 2007 recession, it predicted the recession much earlier in 2006.

The basic idea behind yield curve is this. When long term growth outlook is good, it leads investors to demand higher returns for long term papers (factoring for higher inflation).. In inverted yield curve, as long term prospects are bleak, it leads to lower long term rates as there is large demand for long term papers (factoring for lower inflation etc). See this for insights on inverted yield curve and its implications.

Actually, in India the yield curves have been flat for a while and has inverted recently post RBI liquidity measures. The measures have not worked as rupee has touched 61 and is up by nearly Rs 2 in 2 days of trading. Markets are expecting more measures from RBI to protect Rupee. All this implies the rate rises could be here for longer than expected. This could mean yield curve could remain inverted for longer period of time.

It is interesting to do research on this issue. Is yield curve predicting further slowdown in India or is it just because of current RBI measures? In other words, would yield curve have inverted anyways?

Great times for research and really tough times for policymakers…