Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Foundations

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.

Like our content? Join Capitalmind Premium.

  • Equity, fixed income, macro and personal finance research
  • Model equity and fixed-income portfolios
  • Exclusive apps, tutorials, and member community
Subscribe Now Or start with a free-trial