In the last few months, Indian analysts and economists have spent a lot of time and ink worrying about the likely effects of a full-fledged trade war. Trade war is not even helping the US so it is unlikely to help any other country. Obviously, a trade war will lead to a slowdown in exports and a consequent slowdown in overall economic growth. Both the IMF and the World Bank have projected an impact of 30 to 40 bps due to the trade war. But that is not the immediate worry for India. What is happening on the yield curve is a lot more important. Here is why.
What is the yield curve?
Before we talk about an inverted yield curve, let us step back and first see what this yield curve is all about. Yield curve plots the yield on benchmark debt instruments of different tenures that are issued by the government. Under normal conditions, the yield curve has a positive slope because the longer the tenure, the higher the yields. Risk increases with time and that makes yields dearer. A 10 year bond must command a higher yield than a 5 year bond, which must in turn command a higher yield than a 2 year bond. That is the way the yield curve works. But there are those odd occasions when the yield curve turns inverted. That means; the long term yields fall below the shorter term yields. That is exactly what is visible in the US at this point of time. Let us first understand why this inversion of yield curve is critical.
An inverted yield curve
In the last few weeks, the US yield curve has turned inverted for the first time in the last 10 years. An inverted yield curve means that the yields on the longer term bonds are lower than the yields on the shorter tenure bonds. This situation normally occurs when there is tremendous uncertainty over the future and hence investors prefer to stay at the short end of the yield curve. In the past, such situations have been indicative of a forthcoming recession as a negative slope of the yield has served as a lead indicator. In 1998, the yield curve became inverted and exactly in 2 years by the end of 2000 the US economy had slipped into recession. Again in 2005, the yield curve was inverted and this was followed by a recession from late 2007 onwards. Watch out for that!
What it means for India?
For the Indian economy, it could have important implications. Firstly, an impending recession could mean that the Fed will not be too keen to hike rates and that will reduce the pressure on the RBI. But a weak US markets has never been good news for emerging markets like India. Sectors like IT and pharma do rely on US demand and India’s GDP growth has normally benefited from positive US cues. Above all, weak US growth could mean deflation of asset values and that could be the big worry. For a rally built on liquidity, that is not good news! ©