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Yield curve dilemma: Inflation, investor caution and the prospect of rate cuts
Source: Live Mint
The yield curve is a key barometer in financial markets, illustrating how interest rates vary across bond maturities. Typically, an upward-sloping curve signals optimism about economic growth, with longer-term bonds offering higher yields. However, when the curve inverts—where short-term yields surpass long-term ones—it can raise red flags, often seen as a precursor to economic slowdowns.
India’s bond market has experienced significant shifts in recent years, driven by factors ranging from rate hikes by the Reserve Bank of India (RBI) to geopolitical tensions and global investor sentiment.
In September 2021, India’s yield curve reflected a healthy economy, with a 192 basis point spread between the 2-year and 10-year bonds. However, as inflation surged—partly due to the Russia-Ukraine war—the RBI responded by raising the repo rate from 4% to 6.5% between 2022 and 2023. This led to “bear flattening,” where short-term yields rose more sharply than long-term ones.
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Now, with inflation moderating, speculation is growing around potential rate cuts to ease investor caution and restore a more typical yield curve.
By mid-2024, the spread between 2-year and 10-year bonds had narrowed dramatically to just 2 basis points, reflecting heightened caution among investors and concerns of a potential economic slowdown.
The inclusion of Indian government debt in JP Morgan’s global bond index in 2024 marked a significant milestone, attracting substantial inflows from both foreign and domestic investors. This development not only raised the global visibility of Indian bonds but also affirmed their creditworthiness, encouraging greater institutional investment.
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Increased demand for government bonds has driven yields lower across maturities, as investors sought the safety of these assets amid economic volatility. However, despite inflation stabilizing, the persistently narrow yield spread—just 4 basis points between 2-year and 10-year bonds—indicates continued caution among investors.
Liquidity and banking challenges
A major factor influencing yields is banking liquidity. While improving liquidity, bolstered by increased government spending and reduced short-term borrowing, should lower short-term rates, the deposit crunch facing banks has complicated this scenario, keeping short-term rates elevated.
As banks increasingly turn to high-cost short-term certificates of deposit (CDs) and other funding instruments to cover their funding gaps, short-term rates remain elevated. This has impacted the yield curve, with short-term yields failing to decline in response to improving liquidity, resulting in a flat or even inverted yield curve.
Despite a seemingly favourable liquidity environment, funding challenges continue to put upward pressure on short-term yields. Interestingly, the corporate bond yield curve is also inverted, driven by demand-supply dynamics. Investors appear to be preparing for potential market volatility, opting for the stability of longer-term bonds despite their lower yields.
Inflation outlook and expectations
Inflation in India moderated to below the RBI’s target of 4% in July and August 2024, largely due to the base effect of last year’s high food inflation. However, as these effects diminish and with rising vegetable prices in September 2024, inflation is expected to increase again. Geopolitical tensions and irregular monsoon patterns may further contribute to volatility in food and commodity prices.
The RBI remains focused on ensuring inflation stays durably within its target range before considering any changes to interest rates. For now, the central bank is expected to hold rates steady at its October 2024 policy meeting.
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Looking ahead, fluctuations in yields are likely to be influenced by the interplay of increased government spending, festive season dynamics, and foreign investor inflows. Ultimately, the balance between supply and demand in the bond market will determine the net effect on yields.
If inflation continues to stabilize below 4%, it would pave the way for the RBI to consider reducing interest rates. This could lead to a return to a more typical upward-sloping yield curve, signalling stronger economic conditions and improving investor sentiment.
Mansi Kariya, co-fund manager debt and credit research analyst, PPFAS AMC.
