The tale of India's wagging yield curve

Readers of this blog may be forgiven for thinking that the graph above is a crude animation of a wagging tail, or a cracking whip. The movement of India G-Sec Zero Coupon yield curve in recent times (the graph illustrates movement between April through September 2013) has been as violent as that of the stock market indices and the foreign exchange rates. 

The dotted lines form the bounds within which the yield curve has moved over the mentioned period. There is a spread of over 450 bps for bonds maturing within 6 months, and a spread of 200 bps for the 10-yr maturity G-secs. 

What is a yield curve?

Although any entity which issues bonds may have a yield curve, we will discuss the yield curve in terms of sovereign bonds ('G-Secs' or Government Securities, t-bills, etc). If the issuer (the Indian govt, in our case) is a regular borrower from the money market, at any point of time there are several bonds of different maturities (i.e. the period of time before the principal amount borrowed through the bond is repaid along with interest). 

Therefore, at any point of time the money market is likely to have bonds which mature in 1 month, 3 months, 6 months, 1 year, 5 years, 10 years, 30 years, etc. When the yields (annual return on the invested amount) of these bonds are charted on a graph with maturity on the horizontal axis and yield on the vertical axis, the resultant curve is called the Yield Curve.

This is not to be confused with the graph of the bond yield over time.

A quick primer about yield curves can be downloaded here:

PIMCO Yield Curve Primer 

Basics of Yield Curve Strategies 

Importance of the Yield Curve

In the medieval ages, soothsayers used to divine the future by observing various natural occurrences, flight patterns of birds, organs of sacrificed animals, etc. Economists nowadays use the slope of the yield curve to predict approaching periods of economic expansion and contraction.

The yield curve is probably one of the best-known leading economic indicators. Even as early as 1965, Reuben Kessel (The cyclical behavior of the term structure of interest rates) pointed out that spreads between long-term and short-term rates (for example, Yield of 10 yr bond - Yield of 3 month bill) tend to be narrow or even negative at the start of recessions and widen at the beginning of expansionary periods. 

The yield curve has been shown to predict GNP and GDP growth, consumption trends, investment trends and industrial production with a lead time of around a year to 18 months. The National Bureau of Economic Research in the US actually monitors the yield curve and dates recessionary periods. Data shows that the yield curve has successfully predicted every US recession since 1950 with just one exception. Studies have shown that this is true for many other major developed economies as well.

Do note that this correlation is much stronger in developed economies than in emerging economies, for the simple reason that money markets and debt capital markets in emerging economies are not as liquid or efficient as in developed economies. The yield curve is not the only leading indicator used by policy-makers. Several other indicators are used in conjunction with the yield curve.

What are the factors that affect the shape of the yield curve?

A risk premium is required by investors for the heightened risk of investing their money in a longer tenure bond, rather than a shorter tenure bond. Due to this, long-term bond yields are higher than short-term yields and the yield curve slopes upward. This is the normal shape of the yield curve.

However free market forces may modify the shape of the yield curve. The major forces affecting this shape are:

1. investor expectations for future interest rates, and
2. risk premiums on longer term bonds

* When the yield increases, it means traded bond prices are going down. This means an increase in the yield implies lower demand for traded bonds, higher risk perception etc. Decreasing yields imply higher bond prices in the market. This means higher demand for the bonds and lower risk perceptions regarding the economy and investment tenure.

As the shape of the curve partially depicts investors' expectations for future interest rates and future economic performance, the yield curve is considered to be a leading economic indicator. 

1. Normal shape (gently upward sloping) - A gently upward sloping yield curve denotes expectations of stable economic growth with stable inflation rates. 
2. Steep upward sloping - A steep upward slope implies that there is a wide, positive spread between long-term & short-term bond yields, and usually precedes periods of economic expansion and growth. High growth scenarios also bring the risk of higher inflation (and higher interest rates to control this inflation), therefore risk premia required by investors for longer term investments are correspondingly higher.
3. Downward sloping (or the Inverted Yield curve) - A flat or downward sloping yield curve implies that there is either a narrow spread (flat curve) between long-term & short-term bond yields, or that this spread is negative (inverted curve). Inverted curves have been noticed before economic slowdowns and depressions.

Apart from market forces, the yield curve is also affected by changes in monetary policy (Read: Does Monetary Policy make the Yield Curve move: CRISIL). For example, the increasing interest rates, and liquidity curbs put in by RBI to control inflation have caused an inverted yield curve. Does this mean a (further) slowdown is on the cards for India?

While the 'coming slowdown' theory is the dominant view, some people feel that yield curve signals may not necessarily be the same for emerging markets and developed economies. Lower long-term yields may signify the growing comfort of investors with extended investment horizons in emerging markets. Read: Inverted Yield Curve Signals Lower Inflation, Not Recession

What is the relation of the yield curve with investment decisions, financial markets and the forex market?

In simple terms, an inverted yield curve means that investors feel that the risk of investing in the short-term is equal to or higher than investing long-term. This means corporates avoid capital expenditure in the short-term and investors postpone investment decisions to a later date. This brings down growth expectations and depresses stock valuations, affecting the stock markets. Due to falling valuations, fund managers pull out their investments and park them where the risk-return scenario is better. (Read: FIIs pull out $10.5 b from Indian capital market in June-July)

In emerging economies like India which depend on inflows of foreign funds, this pull out is especially painful as it drastically increases the supply of local currency in the markets, playing havoc with the supply-demand equilibrium in the currency markets. 

Do note that the events do not necessarily occur in the order I mentioned above. Any combination of these events may trigger a shift in the shape of the yield curve.

Further reading:

Yield Curve FAQ at the New York Fed website 

Predicting power of Yield Curve - A study of Indian sovereign yield spread

Yield Curve as a Predictor and Emerging Economies

Request to readers: I would like to compare this with the behavior of the Yield Curves of the other BRICs over the same period, but I need the datasets. Do drop me a message in the comments section if you would like to collaborate regarding this study.