INVERTED CURVE – REALLY, IT’S NO DANGEROUS HAIR-PIN BEND!

about 5 months ago
No Image

 

The Indian markets are on their own; unmindful of all that happens “outside.” For now, the market is in a pre-celebratory mode – it has already concluded that Modi as PM will be back; if we some hiccups later, it would only be account of the number of seats that BJP wins. The mood in India – economics be damned, politics rules!

But while we were rejoicing the jumping indices, there was a happening which worried a lot of analysts and economists world over, so much so that many said it was an indicator of the tough times ahead. Everyone used the one word we all hate – recession.

Last week, for the first time since 2007, the US saw the “inverted” trend. This is the yield curve for the US Treasury Bonds and if it inverts, it is recession. Many say that it is the markets most reliable recession indicator and it is flashing a bright red!

So this is how the curve works – when all things look hunky dory on the horizon, people buy into short term bonds, usually 3-month as they perceive no immediate threat. Thus there are lesser number of people buying long term, 10-year bonds.

Demand and yield work in inverse proportion – when demand goes up, price of the bond increases and yield is lower. That’s the natural order of things – yield on short term bonds in lower than the yield on long term bonds. But last week, the yield curve inverted – the demand for 3-month short term bonds was lower than that for the 10-year US Treasury bonds and yields rose. People might be buying 10-year Treasuries because they expect economic turmoil in the near-term and want somewhere relatively safe to park their money. Fall in growth means lower inflation and this might force central bank to lower interest rates.

This, many economists say is an ominous sign. Since 1955, all the nine recessions in USA were preceded by this inverted yield curve. Only once in last 60 years has this inversion not been followed by a recession in 1960s when growth slowed but the economy did not sink.

So does this mean we are looking ahead at a 2008-like crash? A recession lay ahead? Whoa!!! There is no need to panic so much. Firstly, it is too premature to panic. A finance professor at Duke University, Mr. Campbell Harvey has explained very logically – an inverted curve becomes a recession harbinger only if it remains inverted, on an average for a full-three months, after which downturns too take some time to follow. In 2001, the yield curve inverted for 8 months before it was officially declared as recession. And in 2007, it was 22 months. And how can one indicator alone be enough to forecast a recession?

One more logical reasoning – the US has entered an era of almost perennial low interest rates and low inflation. Both, interest rates and inflation move in tandem with yields. Thus when both are low, wont yields also be low?

And let’s not forget the QE or bond buying program of the US, post the 2008 recession. That program was designed to lower long term interest rates – maybe that impact is also yet to disappear.

The only thing which comes forth from this reading of the inverted curve is that investors are pessimistic about the future. This ‘feeling’ could be dangerous as people will psyche themselves to think that the inversion indicates a recession ahead and they automatically retrench.

Our take? This inversion might not lead to a full blown recession as feared; sentiments are on the ebb, that’s what is being reflected in the rising yield. In India, as we said earlier, politics alone will rule the market sentiments.

 

Understanding made simple:

What is bond yield?

Yield is simple math – coupon rate/face value of bond. Suppose you have a Rs.1000 face value bond and coupon rate of 7%, then the yield is 70/1000 = 7%.

How to co-relate interest rate, yields and bond prices?

An increasing bond price means yields will be going down. And when will bond prices rise? When there is demand. And when will the demand for bonds rise? Demand for bonds rise when people seek safer havens – that is usually how this works. And demand drops when other markets are safer. At the end of it, even bonds at some point of time, reflect more of sentiments. 

How do yields give an indication of the stock markets?

If yields go up, it means there is trouble on the horizon and this always indicates a negative market condition.  Yield and risk go hand-in-hand. Higher the yield, higher is the risk – so you get paid as per the risk in the market.

What about interest rates and bond markets?

Interest rates and yields move in the same direction, so that naturally means interest rate and bond price move in opposite direction.

Popular Comments