What are Yield Curves and how it acts as a leading indicator for slow down
The yield refers to the interest earned on a bond till it matures. A yield curve is a graphical presentation showing the relationship between a bond’s yield and its maturity.
A yield curve describes relation between yield on a short term bond (referred to as short end of the yield) and a long term bond (referred to as long end of the yield). It shows the investor’s expectations on future interest rates. The yield curve is also used as a leading economy indicator.
Factors Affecting The Yield Curve:
Inflation – A rise in inflation leads to a decrease in the purchasing power, , and therefore, investors expect an increase in the short term interest rates.
Economic Growth – A strong economic growth indicates an increase in the yield, resulting in a steeper yield curve.
Interest Rates – The short term interest rates are managed by RBI, while long term interest rates depend on the market forces.
Types of Yield Curve
Normal Yield Curve – is upward sloping where a bond with higher maturity pays a higher yield. The yield on long term bonds are higher than the yields on short term bond.
Steep Yield Curve – A steep yield curve indicates that the long term yields are rising faster than the short term yields. The only difference between a normal and a steep yield curve is that a steeper yield curve has a larger gap between short and long term returns and expectations.
Inverted Yield Curve- is a downward sloping curve where yield on long term bond is lower than the yield on the short term bond.
Flat Yield Curve – is almost like a straight-line curve where the yield on a long term bond and short term bond are almost similar.
Humped Yield Curve – is when the yield on a long term and a short term bond are almost similar and the yield on a medium term bond is high which forms a hump shape.
Indications of Yield Curve
While the short-term interest rates are indicated by the RBI through the repo and reverse repo rates, the long-term interest rates are determined by the market forces. It is the view of the markets on the future interest rates based on teh future inflation in the economy.
Factors like monetary policy inflation and economic conditions causes the yield curve to change shape.
Typically a yield curve is upward sloping (normal) or a steep yield curve as investors need to be compensated for risks associated with holding a bond with longer maturity.
This happens when investors expect interest rates to rise on back of high inflation or excess liquidity in the market as the RBI might increase interest rates to lower inflation or absorb liquidity.
For example, the yield curve in 23rd March was a normal yield curve. During 23rd March 2018 period, the GDP annual growth rate was 8.2 percent while the inflation was around 3.77 percent in September 2018.
An upward sloping steep yield curve generally indicates economic growth as a growing economy will result in increase demand for money (Increase in borrowing for investments) resulting in the interest rates to rise.
Indications of Yield Curve
As shown in the chart, 24th April 2015 shows a flat yield curve. Flat yield curve signals economic slowdown. The yield curve flattens when the RBI tends to curb the effects of rapidly growing economy by raising the interest rate and the causing the yield on short term bonds to increase.
At the same time, on the expectation of falling inflation, investors don’t demand a risk premium for holding the long term bond causing the yield on long term bonds to fall, which causes the flattening of the yield curve.
The inverted yield curve chart shows India Government securities yield curve as on 30 June 2008 depicting a partial inverted yield curve.
During that period, India witnessed falling inflation from 10.89 percent in June 2008 to 1.48 percent in March 2009 and the Repo rate was cut by 350 bps around the same time.
An inverted yield curve is considered as a leading indicator for a slow down. As in India, GDP for 2008-09 fell from 9.3 percent to 6.7 percent.
The author is Head – Sales and Marketing at IDFC AMC.
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