Treasury yield curve inverts: What it means and what does it signal?

Yield curve inversion suggests that the market is becoming more pessimistic about the economic prospects for the near future

On Wednesday, the 365-day treasury bill (T-bill) yield in India rose above the benchmark 10-year bond, signalling a yield curve inversion. The Reserve Bank of India (RBI) sold 364-day notes at a 7.48 per cent yield, the highest since October 2018. The 10-year benchmark 7.26 per cent 2032 bond yield, on the other hand, saw a high of 7.4728 per cent and ended at 7.4547 per cent, as reported by Reuters.

The 364-day T-bill yield has risen by 58 basis points in the last six weeks amid high uncertainty over interest rate hikes and worsening liquidity in the banking system.

What are Treasury Bills and why are they issued?

T-bills are short-term debt instruments issued by the Centre and are presently issued in three tenors, namely, 91 days, 182 days and 364 days.

These are issued when the government needs money for a short period. These bills are issued only by the central government, and the interest on them is determined by market forces.

T-bills were first issued in India in 1917. They are issued via auctions conducted by the RBI at regular intervals. Individuals, trusts, institutions and banks can purchase T-Bills. But they are usually held by financial institutions.

What is yield curve inversion?

The yield curve shows the returns on government securities for various tenures. Generally, the curve slopes upwards, and the returns increase with a longer maturity period.

But when the returns on these securities in the short term are higher than in the long run, it is called yield curve inversion. It suggests that the market is becoming more pessimistic about the economic prospects for the near future.

The term "inverted yield curve" was coined by the Canadian economist Campbell Harvey in his 1986 PhD thesis at Duke University.

Yields of treasury bills are compared with the benchmark 10-year bonds to make the yield curve.

According to a blog by the World Economic Forum (WEF), inverted yield curves have signalled recessions almost successfully every time.

"The worrying trend is that an inverted yield curve in key government securities such as US Treasuries can often foreshadow a recession. For every recession since 1960, an inverted yield curve took place roughly a year before, with just one exception in the mid-1960s," it said.

According to Investopedia, Inverted yield curves are an essential element of economic cycles, preceding every recession since 1956. The inversion of the yield curve tends to predate a recession by 7 to 24 months. 

According to experts, the yield curve inversion may now signal towards recession in developing countries like India.

"Normally an inversion of the yield curve is regarded as an indicator of imminent recession. But this correlation between yield curve inversion and recession is found only in developed countries, not developing countries like India. The inversion happened here due to higher-than-expected cut offs on treasury bills sales, which in turn, was triggered by deficit in the liquidity in the banking system. This declining trend in liquidity and inversion of the yield curve is likely to continue for some more time. But this is not going to impact India’s GDP growth in FY24," said VK Vijayakumar, chief investment strategist at Geojit Financial Services.

When did the yield curve invert last?

Before Wednesday, the yields on 10-year and 30-year came to the same level on February 22. They both closed at 7.39 per cent. On February 8, the returns on US two-year bonds rose higher than the returns on 10-year bonds. The gap between the two had widened to an unprecedented 86 basis points.

The recent inversion may mean that India might face tough economic conditions in the coming days.