Does an inverted yield curve mean fall in the stock market?

The markets have turned volatile since the start of this month and are giving a wild swing on both sides on daily basis. Every analyst worth his salt is trying to predict the future course of market applying his own judgement and experience. One of the leading indicators that have not been used widely in India, is ‘inverted yield curve’. This piece of data helps to predict an economic slowdown, which ultimately impacts the stock market. In the American market, this indicator has been able to predict all the recession in the last five decade.

The basic finance premise is that the yield on long-term bonds should be greater than short-term bonds. This is because as an investor you expect a lower return when your money is tied up for a shorter period. However, you need a higher yield when your money is tied for a long-term. Accordingly, the yield on 10-year bonds should be greater than one-year bonds. Nevertheless, there are cases when the bond yields of shorter duration are greater than the longer duration bonds. This happens when the investor has little confidence in the economy. Therefore, he starts investing in short-term duration bonds as he expects the value of the short-term bills to fall sometime in the future because apex banks usually lower the repo rate, which is tracked by small duration bonds.

In the Indian context, the inverted yield curve has not been a very good predictor, however, once it enters into a negative territory we see equity markets too start falling. In our analysis of last 15 years data, we found four instances (2008, 2011, 2013 and 2015) where the difference between long-term and short-term yield has turned negative and markets too have given negative return during that period.

There is a statistically significant negative correlation between leading indices such as Nifty or Sensex and difference between 10-year bond yield and 1-year bond yield. What this means is that as the difference between yield gets narrower and narrower, chances of equity indices sliding increases. Even the regression analysis shows that 12 per cent of fall in equity indices is explained by fall in the difference between 10-year and 1-year bond yield.

Currently, the difference is getting narrower but nowhere near '0' hence we do not see an imminent fall in the market. Nevertheless, the difference has started narrowing. In this condition, as a mutual fund investor, you should re-balance your portfolio and shift some amount of long-term debt fund to short-term debt funds.