Inverted yield curve in US, does it mean recession in India?

Markets around the world tanked on Friday (March 22, 2019) after long-term bond yields in the US plunged below short-term ones, the first time since 2007. Many consider this inverted yield curve as an ultimate recession indicator. For the last half-century, recessions follow almost 15-16 months after a yield curve inversion, basically like clockwork. The seed of this inversion was set when the US Federal Reserve unexpectedly decided not to hike interest rates. This eroded the markets' confidence in the world's largest economy and triggered fears of another recession. So it is finally time to prepare for an economic downturn in the world’s biggest economy and what are its repercussion for the Indian economy and market?

Before getting into that, first, we should understand why the inverted yield curve is a leading indicator of an economic downturn and how reliable it is.

What is ‘inverted yield curve?’

In normal circumstances yield curve is an upward slope because bond investors expect to be compensated more for taking on the added risk of owning bonds with longer maturities. So a 20-year bond typically yields more than a 2-month bill or 3-year bond. Therefore, the yield curve is a table that draws yields on all Treasury maturities ranging from 1-month bills to 30-year bonds. When yields further out on the curve are substantially higher than those near the front, the curve is referred to as 'steep'. So a 30-year bond will deliver a much higher yield than a 2-year bond.

Nonetheless, sometimes the yield curve ceases to be upward sloping. This occurs when shorter-dated yields are higher than longer-dated ones and this is called an 'inversion'. This happened on Friday (March 22, 2019) for dollar-denominated bonds.

Why does the inverted yield curve mean recession?

The reason why inverted the yield curve spells recession is because as the growth rate slips, the central banks try to stimulate growth by cutting interest rate. Since the central banks usually lower the repo rate, which is tracked by small duration bonds, the yield of the shorter duration bonds spurts. Therefore, the inverted yield curve shows that a recession may be coming.

What does that mean for India?

Outside of the United States, an inverted yield curve has never been a reliable indicator of incoming recessions. Even in the US, it takes a while before recession sets in and normally there are a couple of false positives. Therefore, right now there is nothing to worry for Indian investors and moreover, most of the Indian economy is immune to such slowdown in the US.