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Warning: Inverted Yield Curves = Slowdown

From the FT: EM central banks are doing Fed’s dirty work (needs registration, but you can google click into FT)

Emerging market central banks have been tightening monetary policy to curtail credit growth and slow aggregate demand. If they are successful, the recent uptrend in commodity prices might end. It has been widely accepted that the incremental demand for commodities during the past decade has come from the emerging markets. That incremental demand has been fuelled in part by the easy money and credit conditions noted. However, it might be a mistake to extrapolate from past demand trends, especially in light of emerging market central banks’ increasingly tight policies.

Yield curves are very good forecasters of future economic and profits growth. Whereas the US yield curve remains very steep (with higher interest rates over longer maturities), suggesting robust growth, yield curves in many parts of the world are demonstrably flattening as their central banks’ tightening policies take hold.

India, for example, has one of the world’s flattest yield curves, with the spread between one- and 10-year interest rates now only about 35 basis points. A year ago, that spread was over 250bp. By our estimates, India’s curve might invert over the next several months. Historically, inverted yield curves have consistently signalled significant economic slowdown, if not outright recession.

(Emphasis mine)

But according to CCIL, here’s the 1 year-10 year graph:

1yr 10yr yield spread

(click for larger image)

The analysis doesn’t go well with the past. For most of 2007 – when the markets went up nearly 30% – the spread was under 50 bps. (Except for the bump up in July when two Bear Stearns’ funds went belly up) We never really saw a recession after that inverted curve (GDP growth was like 7-8% throughout).

But this time it might just come true, because in my mind we avoided a recovery on the back of some unimaginable rescue efforts in terms of liquidity. At that begins to ebb and its impact in terms of inflation comes to the fore, we’ll have to react by slowing down, probably dramatically. Let’s see.

  • Ankur Lakhia says:

    >Deepak sir,

    I read once that in past 100 years of US history, if yield curve inverts and stay inverted for 90 days or more, it has followed by recession and significant stock market decline, with some time gap. However, I have following two issues in applying this logic to India:

    1) In globalised capital flows, Indian yield curve inversion is not significant event. Big 3 – US, Euro zone & Japan – and to some extent UK and China, matter. Easy conditions in these big economies would undo impact of indian yield curve inversion.

    2)Indian bond market at long end is not liquid and basically controlled by RBI. Hence, long rates per indian 10 years bonds do not necessarily show correct picture.

    Therefore, it would be incorrect to look at indian yield curve in isolation. I suggest following two measures to account for above two issues:

    1) Foreign exchange reserve would be best gauge of capital flows. Hence, if yield curve invesrsion accompnies by falling or stable forex reserve, it would take care of first concern I raised above and it would be be correct to interprete it as negative imapct on economy and stocks.

    2) Instead of looking at 10 year bond yield, one needs to look at average landing rates to average corporate. In US, landing rates are tied to 10 year tresary yield. However, in India, it should be best judged by bank landing rates rather than bond yield due to second concern I raised above.

    Your thoughts please.