MC Explains: All you need to know about yield curve inversion

MC Explains

Amid tight liquidity in the banking system, the bond market witnessed a yield curve inversion between short-term treasury bills and 10-year government securities in February.

A yield curve inversion happens when the yield on short-term debt instruments is higher than on long-term instruments. After every treasury bill auction in February, the short-term cut-off yield has remained above the 10-year benchmark bond yield.

If you want to know a little more about yield curve inversion and its impact on the economy, here’s an explainer.

To begin with, what is yield curve inversion?

Yield curve inversion means short-term bonds yield trading at a higher yield than longer-term bonds.

For instance, on February 28, the cut-off yield on 182-day treasury bills was 7.1673 percent, while the 364-day treasury bills and 10-year benchmark bonds were trading at 7.1199  and 7.0668 percent, respectively. This reflects an inversion in yields.

This has been happening quite frequently in the past few weeks because the yield on short-term securities is under pressure due to tight liquidity in the banking system.

Also read: Bond market yield curve inversion indicates tight liquidity

Why did the inversion happen?

In the last few months, tight liquidity conditions have pushed short-term rates higher, whereas long-term bond yields have remained either stable or fallen, resulting in a yield curve inversion.

Currently, liquidity in the banking system is estimated to be in a deficit of around Rs 1.89 lakh crore, per the Reserve Bank of India (RBI).

What does yield inversion signal to the markets?

Yield inversion usually signals an upcoming recession. Thus, the yield curve has serious implications for financial markets. If the market predicts economic turbulence, and that interest rates will fall in the long term, investors rush to buy longer-dated bonds.

In the current scenario, the inversion does not indicate recession, but tight liquidity conditions.

What is the RBI’s stance on liquidity?

The central bank keeps supporting liquidity with variable rate repo auctions, providing some comfort to short-term rates. But again, due to some outflows from the banking system, short-term yields go up.

On the other hand, long-term bonds are seeing a lot of demand from foreign as well as domestic investors. The demand for government securities has increased after the announcement about the inclusion of Indian bonds in the JPMorgan Global Bond Index-Emerging Markets.

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How often has the yield inversion happened recently?

On January 17, Moneycontrol reported that the Indian debt market had seen a yield curve inversion between 182-day Treasury Bills and 10-year government securities, which money market experts attributed to tight liquidity conditions in the banking system.

After that, since the start of February, every week has seen a yield inversion between 10-year bonds and certain short-term treasury bills.