In any healthy economy, bondholders typically demand to be paid more — or receive a higher “yield” — on longer-term bonds than they do for short-term bonds. That’s because longer-term bonds require people to lock their money up for a greater period of time — and investors want to be compensated for that risk. In contrast, bonds that require investors to make shorter time commitments say for three months, don’t require as much sacrifice and usually pay less. In short, In a healthy economy, 10 Year government bond yield should be higher than 1, 2 or 7 years.
Understand it this way. Just think about the deposits in your bank account, which are in many ways a loan to the bank. You can withdraw that money at any time, so the bank doesn’t pay you a high-interest rate. By comparison, if you lock up your money in the bank for a year or longer, you’ll get higher rates. The bond market works similarly: The longer you lend your money, the higher the return you’ll get.
What does an inverted yield curve mean?
When interest rates (yields) on short-term bonds move ahead of those payable on long-term bonds then it shows that investors worried about growth are investing in long-term bonds, pushing up their prices. Bond prices and yields move in opposite directions. This is called an inverted yield curve.
What does an inverted yield curve indicate?
Historically, when yield on the 10-year US government paper has fallen below the 2-year one, the recession has followed there. On 14 Aug 2019, that’s what happened. At one point on Thursday as well, the yield on 10-year note was 1.5708% as against 1.5710% on 2-year although balance was later restored.
Yields on three-month treasuries have ruled higher than 10-year note for five months, but the gap had widened Wednesday. This means bondholders are worried about economic weakness and not inflation
The more pronounced inversion is a sign that people are more concerned about the fallout of the trade war between the U.S. and China and worried by signs that economic growth may be slowing around the globe.
Here comes, a must watch video: Are we heading for a global recession? — BBC Newsnight
Why is the yield curve inverting then?
Much of the blame has been put on the US-China trade spat. When it started over two years ago, there was hope it would get resolved as both sides kept the talks going. But a deal hasn’t come through even as Trump has put off the latest round of tariffs on Chinese imports (video games, smartphones, laptops, toys) to 15 December. Tariffs on tools, apparel and some footwear take effect on 1 September. The trade tiff between the two largest economies is creating uncertainty and investors are rushing to buy US bonds, a safe haven.
So, does this mean the US is staring at a recession?
Recession is defined as two straight quarters of negative growth. It may be a little early to say “yes”.
So why do investors care?
The fact that people are willing to take such little money for their long-term bonds suggests that they aren’t too worried about inflation. If they aren’t too worried about inflation, it also suggests that they expect the economy to grow more slowly in the future. Inflation usually picks up when the economy is hot.
The yield curve inversion also suggests that investors expect the Federal Reserve to keep cutting short-term interest rates in an effort to boost the economy.
Fed officials cut the benchmark interest rate by 0.25% points last month, the first-rate cut since December 2008. Investors are now expecting the Fed to cut rates by another 0.25% points during its next meeting in September.
Back to India
As I can witness, In India, 7 Year Gov Bond yield is trading higher than the 10 Year Gov Bond.
Bond prices and yields move in opposite directions. India’s benchmark government bond yield has dropped to its lowest since the subprime crisis of 2008.
The gap in yield between highest grade corporate bonds over comparable government securities has increased. As credit events singed bonds of even the highest grade companies, investors flocked to the safety of government debt. This also means that borrowing costs of corporates have not come down in proportion to drop in interest rates.
The lower yield from the Nifty index relative to government bond yield typically means the stock market is expensive. However, narrowing of this gap indicates that risk-reward situation has improved in favour of equities. The bond-equity earnings yield gap indicates how the risk-reward ratio is tilting in terms of macro asset allocation. Earnings yield is the inverse of price-earnings ratio and calculated by dividing earnings per share by the market price of the stock.
Inverted yield curve is considered a leading indicator of impending recession. In the US, since 1967, every major recession has been preceeded by inverting of the yield curve. Typically, investors demand higher yields from longer-term bonds to compensate for the higher risk of keeping their money tied up for a longer period. But when yields on shorter term bonds rise above longer term bonds, it signals that the bond market is expecting trouble ahead.
Is India witnessing a similar situation?
No, But India’s economy is facing other problems. Its financial sector is grappling with trillions of rupees in bad debt and resolution of most cases is still slow. Fear of probe agencies over fresh bad debts and a liquidity crunch are hampering lending by banks. Even as the world talks about negative interest rates, India continues to see high-interest rates. Its 10-year bond yield rose for the fifth consecutive session to 6.6% — a level is last seen on 4 July. The country is still the second fastest-growing large economy. Automobile slowdown is also playing a vital role.
Is it time to worry?
Not yet. There are reasons to have hope the economy won’t go into a recession. Such as:
- The labor market is strong, and most people who want a job are able to get one.
- Consumers are still opening up their wallets, which is lifting economic growth.
- Even if the shift in the yield curve is followed by a recession, the slowdown might not happen right away. A look back at previous downturns shows that yields have typically inverted an average of 18 months before the start of the recession.
Hope for the best!