From time immemorial, mankind has been fascinated by curves and figures, both animate and inanimate! When one talks about equity markets, the figure that one watches is the market index like the Sensex or Nifty. When it comes the fixed income securities, financial analysts and economists as also policy makers keep watching the Yield Curve.
Yield Curve is a graphical representation of interest rates on debt for a range of maturities from a single issuer. It shows the yield an investor is expecting to earn if he lends his money for a given period of time. The graph displays the bonds’ yield on the vertical axis and the time to maturity across the horizontal axis. The curve may take different shapes at different points in the economic cycle, but it is typically upward sloping. But there are many kinds of yield curves, such as, normal, inverted, steep, flat, humped, etc.
While any issuer ( borrower) — including you and me — can have a yield curve, the yield curve that everybody in the market watches and dissects is that of the government of the country. The Government of India, for instance, periodically borrows money from the market through auctions of treasury bills and government securities. To plot its yield curve, you draw a graph of the current market interest rates on its 91-day, 182-day and 364-day treasury bills, and its 10-year, 20-year and 30-year borrowings. For simplicity though, most market watchers use the spread between one-year and 10-year borrowings to gauge the shape of a country’s yield curve.
The current yield on the Indian government’s one-year borrowings is 5.1 per cent, while that on its 10-year borrowing is at 6.6 per cent, making for an upward sloping yield curve. In the US, the government is borrowing one-year money at 1.6 per cent and 10-year money at 1.8 per cent.
The bond market, it is said, is a better barometer of the economy than its volatile cousin — the stock market. The behaviour of the yield curve is closely watched because interest rate moves can tell you a lot about what very smart institutions think about the future health of the economy. A steeply upward sloping yield curve, like the one we are seeing in India, is a sign that markets expect interest rates to spike up sharply in future. The increase in future rates can come about due to several factors — inflation shooting up, the economy reviving and pushing up the demand for money, or the markets perceiving a higher risk associated with government borrowings due to a fiscal deficit overshoot. Whatever the reason, the net effect of an upward sloping yield curve is to make long-term borrowings costlier for everyone. The government paying high rates for long-term borrowings means a large chunk of your tax money going to fund its interest costs.
An upward sloping yield curve like India’s is however seen as quite desirable, compared to the ‘inverted yield curve’. A few months ago, market watchers sounded the alarm bells on the US economy after the difference between its one-year and 10-year paper turned negative. An inverted yield curve is seen as a sign of an economy that is heading into a tailspin, because it is usually a shrinking economy that prompts aggressive rate cuts. Also, logic demands that lenders demand higher rates for giving out 10-year loans as opposed to one-year loans. When they’re willing to lend 10-year money at lower rates, it’s a sign that they expect deflation. There have been studies showing that in the US, recessions usually follow within two years of the yield curve inverting.
In December 2019, Reserve Bank of India did surprise the market when it decided to borrow a page from the US Federal Reserve playbook. It launched, what market watchers call, ‘operation twist’. It purchased Rs 10,000 crore of the 10-year government benchmark bonds and sold an equal amount of short term securities through an auction. Although the net cash flow from this operation was zero, it had the effect of reducing longterm rates. This was done because the country’s sovereign bond market was facing a situation that cuts in the repo rate alone were not able to address. Quite like the stock market, the bond market was not reflecting the true state of the economy. The hardening of yield on 10-year benchmark bonds for some time and the upward shift in the yield curve – the gap between the rate of interest on short and longer-term bonds – suggested revival in the overall economy. It also indicated financial markets expecting future interest rates to go up sharply. Both these underlying indications were not born out in the Indian context at present given the continuing economic slowdown and moribund investments.
When an economy is stagnant or slowing down, the yield curve should rather be flat, suggesting no or, little difference between short and long term securities of similar nature. The yields on domestic bonds did not mirror this economic logic, of late. The gap between yields of short (one-year) and long tenor (10-year) bonds remained close to 1.5 percentage points or the highest compared to other Asian peers or even the developed market. In the US, the gap is close to a quarter percentage points.
The yield on 10-year benchmark 2029 bond did not reflect the effect of monetary easing (rate cut) and remained in the range of 6.60%and 6.75%. On December 5, 2019, however, it rose above the psychological 6.80% mark, soon after the RBI announced a pause on the policy rates. This created a gap of 1.65%, between the RBI’s repo rate of 5.15% and the yield of 6.80% on the 10-year benchmark paper, which marked an abnormally high spread or difference between the rate of return between these two investments. Usually, the spread is less than 50 basis points (bps) when the central bank’s policy stance is accommodative.
Why did the benchmark yield rise so much and why the yield curve become steeper? The RBI had not signalled a change in its stance. It remained accommodative. The curve also moves upward when the market senses a larger than expected fiscal slippage and a bigger than expected borrowing from the government. Whatever may be the reason, the RBI appears to have sensed the government’s forthcoming moves and the consequent mood of the market. And, that is the reason, it may have taken an unconventional step of buying the long term securities to bring the interest rates down on such debt paper, which is expected to boost the economy when the conventional repo rate cut is not sufficiently effective in doing so. RBI Governor Shaktikanta Das had made it clear on the day of the last monetary policy that even after a huge 135 bps cut, the transmission to the government securities market, had been partial at 113 bps on 5-year government securities and a worryingly pessimistic 89 bps on 10-year government securities. He had given an indication that the conventional tools had not been working optimally.
The 10-year bond yield is the benchmark for interest rates on all fixed-rate loans. These include loans for home, auto and other consumer durables. Lower fixed rates will allow these businesses to expand at a lower cost and also result in economic expansion. On the contrary, higher bond yields hamper transmission of rate cuts by the central bank and make borrowings by the government costlier. Besides, companies borrowing through bonds, also have to pay more. Moreover, banks suffer valuation loss when bond yields rise and bond prices fall.
The yield on the 2029 debt fell as much as 16 basis points to 6.59% after the RBI announced operation twist through special Open Market Operation (OMO). That was the steepest fall in the 1-year benchmark paper, making it Asia’s top performer. But keep your fingers crossed; even as monetary policy seeks unconventional tools to spur the economy, budget 2020-21 which is round the corner will have to pull out quite a few rabbits out of the hat to stimulate a slowing economy.
