Inverted Yield Curve and Recession

Inverted Yield Curve and Recession

Kamaraj IAS Academy | Inverted Yield Curve and Recession
  • March 26, 2019, 3:21 pm

NEWS: Bond yields drop, World economy towards recession


Bond Yield

The bond yield is essentially the amount or percentage of return that an investor can anticipate to receive from a bond issue within a specified period of time


What's triggering recession fears in the US?

Global markets fell on Monday amid concerns of a slowdown in global economy and recession in the US. Japan's Nikkei hit a five-week low after diving 3.1 percent for its largest one-day percentage fall since late December. South Korea's Kospi index declined 1.7 percent while Australian shares faltered 1.1 percent. Chinese shares were also dropped with the blue-chip CSI 300 index down 1.4 percent. Japan's Nikkei closed down 3% on Monday, while Hong Kong's Hang Seng  shed 2%. Concerns about the health of the world economy heightened last week after cautious remarks by the US Federal Reserve sent 10-year treasury yields to the lowest since early 2018.US Federal Reserve said that it would not raise interest rates this year. The comments were seen as central bank's affirmation of negative outlook for the world's largest economy. The Central bank's stance led the US 10-year treasury yields fall below three-month rates for the first time since 2007 on Friday.

Historically, an inverted yield curve - where long-term rates fall below short-term - has signalled an upcoming recession.


What is an Inverted Yield Curve?

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is considered to be a predictor of economic recession. It means  Longer-term Treasury yields have been falling this year, in part on worries that economic growth is slowing around the world. When investors become nervous, they often abandon stocks and other risky assets and look to Treasurys, which are among the world's safest investments. High demand for bonds will send yields falling.On the contrary, Shorter-term rates are influenced less by investors and more by the Federal Reserve, which raised its benchmark short-term rate seven times over the past two years. Those rate hikes had been forcing up the three-month yield.

Normally, yields of longer-term papers are higher than yields of short term papers, given the risk involved in holding a debt instrument over a longer period of time, taking into account the risk of inflation and other uncertainties such as term premium. So, in normal circumstances, yields of 10-year treasury papers should be more than three-month yields of Treasury bills.


Impact On India Markets

Stock markets across the globe took a heavy beating on Monday as fears of US recession loomed large among investors after the US 10-year treasury yields fell to the lowest on Friday. The domestic equity market, too, fell prey to the global-sell off, that saw benchmark indices Sensex and Nifty plunging nearly a percent. Besides, contraction in German manufacturing activity and a slump in the French manufacturing and service sectors added to investors’ fears.

Indian Domestic stocks and spreads (10-year Government Securities and three-month Treasury Bills) are not as correlated as in the US. There hasn't been any correlation between Nifty and US Spreads, as well. Hence the impact on Indian markets is less compared to other european and global markets


What lies ahead?

It is  believed Indian markets rallied too far too soon and hence, a correction has to be done and the matter will subside owing to derivatives expiry and upcoming Lok Sabha elections.Indian markets were due for a correction anyway and the inversion of the bond yield curve has provided the trigger for the same. So , a correction whiuch is generally defined as a 10 percent or greater decline in the price of a security from its most recent peak has to be done in Indian market to bring stability and to bring at par with the demand and supply forces to reduce speculative effec on the market. Correction will show a real market sentiment to be reflected in market and removes false raises due to speculation.