All you wanted to know about yield curves

In recent months, business media around the world has displayed an unusual obsession with curves — yield curves. A few months ago, analysts in the US were fretting about an inverted yield curve, saying that this was a sure sign of a coming recession. In India, everyone’s now worrying about the opposite thing — an unduly steep yield curve. But why is the shape of the yield curve so important to business folk?

A yield curve is the graph you get by plotting the interest rates at which a single borrower can take loans from the market, for different time periods. While any 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 through 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’re 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 upping 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 treasury bill 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.

If you’re a fixed income investor, the yield curve can tell you whether the markets expect interest rates to rise or fall in future. India’s upward sloping yield curve today tells you that the market expects a bounce-back from the low levels of today. As the safest borrower in the economy, the government’s yield curve also sets the floor for all other borrowers. Therefore, an upward sloping yield curve would require companies and NBFCs to pay higher rates to their long-term bond or deposit investors.

Does the economy have curve-balls in store for you? Track the yield curve to know.

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