Simply Put - Flattening Yield Curve

Two friends sip their evening chai at their regular hang-out and the following conversation ensues.

Aditya: Here, have these pakodas.

Vamsi: These pakodas are so flat! Reminds me of flat yield curve that experts were discussing on TV today, although I could not understand what they meant. What is that, do you have any idea?

Aditya: Oh! Flat yield curve means that there is very little difference between the yields of short-term and long-term bonds with same the credit quality. For e.g., the 364-day T-bill is yielding around  6.90 per cent, while 3-year and 5-year G-secs are yielding 7.00 per cent and 7.23 per cent, respectively, compared to the 10-year G-sec yield of 7.32 per cent.

Vamsi: Ah Ok. Can you please elaborate?

Aditya: Fine. Let’s talk about bond yield first. When we speak about bond yields, we mean the returns that an investor would get if she held it till maturity. Yields and bond prices move in opposite directions. When bond prices rise, yields decline and vice versa. In recent times, the RBI has been raising its repo rates, which causes the price of existing bonds to drop, thus increasing the bond yields. This has led to increase in the yields of short and mid-term bonds, it is now close to the 10-year Government securities.

Vamsi: I get that, but what does it imply?

Aditya: This implies that investors do not have any incentive to invest in long-term instruments and the lenders would also want to advance funds for shorter periods.   

Vamsi: But is that a cause for concern?

Aditya: The flattening of the yield curve happens mainly due to rising repo rates. When the repo rate rises, the cost of borrowing also increases, which may slow down economic activity. Therefore, the flattening of yield curve is generally considered as an early sign warning sign for economies of an impending slowdown.

Vamsi: Interesting. But if the rise in interest rates lowers the price of existing bonds and pushes the yield upwards, then the 10-year G-sec yield should rise and therefore the yield curve will not flatten, won’t it?

Aditya: The 10-year G-sec yield isn’t rising even when the repo rates are rising because in the long term, the expectation is that the situation will normalise with short-term interest rates coming down. The yield curve is then expected to normalise.

Vamsi: Great! I think I must start planning my investments accordingly.

Aditya: All in due time. Munch on the pakodas now!

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