Explainer | How yield inversion in US Treasury impact Indian market

“Such an “inversion” has been a reliable indicator of a looming recession and the end of a bull market,” HDFC Securities said in a report.

Past Occurrences:

The phenomena is not new to equity market. Inversions of that spread have preceded each of the past seven recessions, including the 2007-2009 contraction, according to the Cleveland Fed.

They say it’s offered only two false positives — an inversion in late 1966 and a “very flat” curve in late 1998.

“Meanwhile, recessions in the past have typically come around a year after an inversion occurred. Data from Bianco Research shows that the 3-month/10-year curve has inverted for 10 straight days six or more times in the last 50 years, with a recession following, on average, 311 days later,” said the report.

The Duke CFO survey, a poll with almost 25 years of history, recently showed that 82 percent of chief financial officers in the US believe a recession would start by the close of 2020. US economy is late into the business cycle.

The Great Recession ended, according to the National Bureau of Economic Research, in June 2009. The average time to recession in the modern era is 58 months—and we are now at 117 months, or more than double the average.

Reasons for yield inversion:

HDFC Securities highlighted that an inverted curve can be a source of concern for a variety of reasons: short-term rates could be running high because overly tight monetary policy is slowing the economy or it could be that investor worries about future economic growth are stoking demand for safe, long-term Treasury, pushing down long-term rates. Bond prices move in the opposite direction of yields.

Implications of such inversion for the US:

The yield curve, however, isn’t a great market-timing device. Recessions usually begin six to 18 months after inversion, and the stock market can continue to rally well after the yield curve starts flashing red.

HDFC Securities said that one-day inversion doesn’t mean much by itself. Monitoring of the weekly or monthly average of the yield movement would throw a better light into the situation. Ideally, the inverted spread should be visible for 10 straight days.

Implication on the Indian Markets:

Indian markets and spreads are not as correlated as in the US. This is clear from the chart below. After the spreads dipped into negative, there has been no significant fall in the Nifty even with a lag (except in 2015-16). Let us also compare the correlation between Nifty and US Spreads.

The year 2000, Indian markets were not so much interlinked with the markets abroad due to the limited presence of FIIs and hence no major impact of negative spread in 2000 was seen in Indian markets.

In 2008-2009, Nifty made a top about 14-15 months after the spread went negative. We are now again witnessing negative spreads in the US after a gap of more than 11 years.

“We need to monitor whether these negative spreads continue for two more weeks (current spread is just -3 bps on one day vs high of -56 and -83 bps seen in the past two occurrences) and then wait for the correlation with the Nifty to play out with a lag,” the note said.

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