what on earth is a yield curve.
Think about it this way. The government needs to borrow money from us to fund its various expenses, right? And when it wants to borrow money, it issues something called a bond. This is a more formalized IOU certificate. It’s a promise that the government will repay what it borrows. And tack on some interest for our troubles (View Highlight)
Typically, the longer the borrowing tenure, the higher the interest rate it has to pay. (View Highlight)
The logic is simple — there’s a lot of uncertainty associated with a long-term loan. You don’t know what could happen in the next 10 or 20 years. Governments could change. The world economy could collapse due to a financial crisis. Even war could erupt. And in order to compensate for all this uncertainty, as a prudent investor, you ask for a higher interest rate from the government. You might lend the government money at 7% for 1 year. But you ask for 9% when it’s for 10 years. (View Highlight)
So you take the interest rates on all these bonds — with maturities of 1, 3, 5, 10, 20 years — and plot them on a piece of paper. You join these dots together and you get a squiggly line.
That, folks, is the yield curve. And in a normal world, this line gently slopes upwards. Because as we said, “the longer the borrowing, the higher the interest rate.” (View Highlight)
But here’s the thing now. The yield curve in India did something freaky a couple of days ago. It inverted. It turned upside down. It sloped downwards. (View Highlight)
When the government tried to borrow for 1 year, people demanded to be paid 7.48% (the interest or the yield). On the other hand, a 10-year bond was giving 7.47%. And as per Reuters , the last time something like this happened was way back in May 2015. (View Highlight)
And if you translate that into plain old English — people are betting that the near future will be worse than the future far away. (View Highlight)
See, people could be asking for more money today because they think that inflation is going to remain high. And if that’s the case, the central bank could increase interest rates quickly to combat it. But when interest rates rise, it quells demand. It pinches the appetite for borrowing money. People might spend less. And that’s a bad thing for economic growth. (View Highlight)
That’s why people fear an inverted yield curve. They think it’s a bad omen. (View Highlight)
Here’s what a couple of researchers found when they looked at Indian data between 2005 and 2018. They checked to see if the yield curve could predict a slowdown in quarterly GDP (after stripping out the agricultural component) and saw that it got it right a whopping 90% of the time! (View Highlight)
And the thing is, this yield curve inversion has struck the US too. In a big way. The difference between the short-term bond yield and the long-term is at its highest level since 1981! And over the past five decades , an inverted yield curve is almost always followed by a recession within a year or so. (View Highlight)
Okay. Let’s say that investors believe we’ll suffer from high inflation in the near future. And that the inflation will be 7%. So they ask for a higher interest rate from the government bond now. Say 7.50%. This way, they can make at least 0.50% worth of real money. (View Highlight)
But these investors also believe this high inflation is an anomaly. They think that inflation will quickly cool to the Reserve Bank of India’s (RBI) target of 4%. And that the central bank won’t even have to raise interest rates by much to crush demand and inflation. So it won’t have a bearing on economic growth. So they’re quite content with a 7% interest rate for a long-term bond. They know the big picture is the sweet 3% real return they’ll make. (View Highlight)
And if you think about this example in ‘ real’ terms , that means the yield curve is sloping upwards. It’s 0.50% in the short term and 3% in the long term. (View Highlight)
