EconomyView. Does The Monetary Policy Make The Yield Curve Move? December Introduction ...

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1 EconomyView Does The Monetary Policy Make The Yield Curve Move? Analytical Contact: Poonam Manjul Vidya Mahambare Introduction This article analyses the extent to which the monetary policy changes in India have influenced the behaviour of the yield curve - a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. It also analyses the importance of the yield curve as a lead indicator of future economic activity and inflation, as is the case with a number of other economies. We have constructed the yield curve for India using 1-year and 10- year government securities. Apart from providing information about the future state of the economy, the g-sec yield curve serves as an 17

2 important benchmark to set the cost of funds in other debt markets Figure 1.1: Policy Rates and inflation such as corporate bonds and bank loans including the housing loans, and is an important indicator of investment climate. The more mature, transparent and liquid the bond markets are, the more useful information they carry. We have focused only on 1-year and 10-year government securities, given that the g-sec for maturities other than these are largely illiquid, and hence, their yields do not truly reflect expectations of future economic activity or inflation. Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Mar-07 Apr-07 May-07 Jun-07 Oct-07 Nov-07 Dec-07 Apr-08 May-08 Jun-08 Jul-08 Impact of monetary policy on the yield curve The yield curve indicates the expectations about the economic activity With the liberalisation of the financial sector in the last few years, the short term interest rates in the economy are influenced to a large extent by the monetary policy changes. The monetary policy actions also influence market expectations of the future short term rates for the next couple of years. The interest rates for longer horizon, however, are also influenced by factors other than the policy actions. For example the 10-year rate, defined as a weighted average of the current one-year rate and nine one-year forward rates depend partly on term premium which is the additional compensation that investors require for the risk of holding longer-term instruments. The term premium, in turn, depends on the extent of real interest rate risk and the inflation risk. Nonetheless, the long term yields also indicate the market expectations of the future economic state of the economy. In the following analysis, we examine the relationship between the policy, the state of the economy and the yield curve in India. Source: RBI The one-year g-sec have moved in line with the policy changes A close observation of the data reveals that the short-term rates have largely responded to the changes in the monetary policy since April 2006 (fig 1.2). Monetary tightening, which began in June 2006 with a hike in the repo rate, continued till the end of the March 2007, taking the repo rate to 7.75 per cent with a cumulative hike of 125 basis points. In addition to this, CRR, which was kept unchanged till December 2006, was hiked by 100 bps during the last 3 months of Accordingly, the yields for 1 year g-sec hardened during the period from 6.54 per cent on the day just before first hike in repo rate was announced on June 9, 2006, to 7.88 per cent on March 31, The yield of 10-year paper also kept increasing during this period as is evident in figure 1.2. However, how have the longer-term interest rates been behaving as compared to short-term rates during this time can be best understood by constructing a very rough yield curve using the 1-year and 10-year g-sec yields for India (fig 1.3). Figure 1.2 : G-Sec Yields and Monetary Policy Rates During , the tightening of the monetary policy began in June 2006 following an increase in inflation and inflationary expectations (fig 1.1). When the inflation level rises beyond the RBI's target, it takes the necessary monetary actions to tame it by announcing the hike in key policy rates or the cash reserve ratio (CRR) so as to reduce excess liquidity in the system. An increase in Repo rate, the rate at which RBI lends money to the commercial banks, and an increase in CRR, a percentage of the total deposits commercial banks have to keep with the RBI as deposits, is aimed at increasing the cost of loans by reducing liquidity. Source: CCIL and RBI 18

3 Figure 1.3 : Yield Curve on Selected Time Periods Figure 1.4: Yield Curve Spread and Policy Rates Aug-06 Sep-06 Aug-06 Oct-06 Sep-06 Nov-06 Oct-06 Dec-06 Nov-06 Dec-06 Mar-07 Mar-07 Apr-07 Apr-07 May-07 May-07 Jun-07 Jun-07 Oct-07 Oct-07 Nov-07 Dec-07 Dec-07 Apr-08 May-08 Apr-08 Jun-08 May-08 Jul-08 Jun-08 Jul-08 Source: CCIL Source: RBI and CCIL The yield curve during suggested faster economic expansion Figure 1.3 shows an "upward-sloping" yield curve for April 2006 and April When the yield curve is upward sloping, it implies that as the one-year rate rises, the one-year forward rates for the rest of the period in future rise above the current one-year rate. The upward sloping curve generally indicates periods of economic prosperity and reflects investor expectations of sustained economic growth. Inflation will therefore increase, leading to further monetary tightening and rising short term rates. Hence, investors expect the spot rate in the future to be higher than the present. The second factor influencing the long term rates, namely, the term premium, also rises, as uncertainty about the future rate of inflation increases and investors demand higher yields to hold longer maturities. The similar economic environment of period around April 2006 explains the upward sloping curve then. Steep yield curves were observed in the subsequent few months when the spread between 1-year yield and 10-year yield widened to more than 100 basis points (fig 1.4). The yield curve spread is the difference between long-term and short-term interest rates, and is useful in predicting the performance of an economy. Higher long term interest rates give the financial market an incentive to lend money. Credit expansion, in turn, stimulates economic expansion. Such indeed was the economic scenario in However, with liquidity tightening in the money market, the yield curve flattened with the spread between 1-year and 10-year yields narrowing to 30 basis points at end-march In the yield curve suggested the impending uncertain economic environment Between April 2007 and April 2008, the repo rate was kept unchanged but CRR was raised from 6.5 per cent to 7.75 per cent. During the first quarter of , the1-year rate declined marginally, possibly due to low-inflation expectation. This resulted in a marginal widening of spread between the yields of short-term and long-term government securities (as seen in fig 1.4). For rest of , both 1-year and 10-year yield changed little. In essence, the yield curves between April 2007 and April 2008 were almost flat and the spread between the yields close to zero per cent. The flat curve indicates that the 1-year rate and the future expectations for 1-year forward rates are almost the same. This type of yield curve sends signals of uncertainty in the economy, implying that the investors are unable to take a firm call on 1-year forward rates. Historically, the slope of the yield curve has tended to decline significantly in prior to an economic slowdown. A flat yield curve does not compensate the bond holder for the additional risk associated with buying a longer term to maturity bond. In other words, the term premiun declines during such period. To the extent that long-term rates have been influenced by macroeconomic conditions and resulted in the flattening of the yield curve, the market participants expected the monetary policy to ease and interest rates to come down in near future. This might explain the flat yield curve during , when the inflation in India was at unprecedented low levels and easing of the policy was on cards, if not for the food and fuel price increases in the following period. 19

4 Yields in the long-term paper hardened in the beginning of , Figure 1.5: Yield curve on selected time periods in 2008 as the domestic inflation started increasing with the sharp increase in global commodity prices, especially crude oil prices. Thereafter, yields began to ease on the back of comfortable liquidity conditions and the RBI's decision to keep the policy rates unchanged in the Annual Policy Statement for However, following the hike in repo rate by 125 bps between June-July 2008, yields of both 1-year and 10-year paper rose sharply. While yield of 1-year government paper rose from 7.8 per cent in May 2008 to 9.3 per cent in July 2008, the same for 10-year paper increased from 7.92 per cent to 9.23 per cent during this period. For the next 2 months, while the policy rates remained unchanged, the yields fell with the softening of crude oil prices. But this period witnessed an inversion in yield curve as the yield of 10-year paper fell below that of 1-year rate (fig 1.5- the yield curve for Sep 08). The central bank went in for a series of cut in repo rate and CRR in the subsequent months following the global financial crisis. Since then, the government securities yields have eased. Over this period, as the graph 6 suggests, the yield curve is almost flat again. An inverted yield curve in September 2008 suggests future economic slowdown An inverted yield curve, as experienced in August-September 2008, occurs when long-term yields fall below short-term yields. Historically, an inverted curve has indicated a worsening economic situation. In addition to potentially signaling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. As a result, lower bond yield is offset by low inflation. The global financial crisis in the middle of 2008 led to an expectation of worsening of domestic economic situation as well. This may have resulted in an inverted yield curve. The yield curve once again became flat by October 2008 (fig 1.5). Investors seem unsure about the economic conditions in the future. Investors expect economic activity to slow at some point in the future, but are uncertain about its magnitude. If the investors expect that economic weakness requires further policy easing in the medium term, they mark down their projected path of future spot interest rates, causing the yield curve to flatten. Source: CCIL The 10 - year yield falls less than the 1-year yield following the policy easing suggesting increased risk aversion The yields of both long-term and short-term g-secs eased in November 2008 following further loosening of the monetary policy. The shortterm yields, however, have dropped much more than the 10-year yields. As a result the yield curve in November 2008 (November 1-15), has again upward sloping with the yield spread widening to over 70 bps (fig 1.3 and 1.5). Generally, whenever investors expect economic expansion they shift their money to short-term securities away from long term bonds. This shift leads to the lowering of short-term yields and an increase in long-term yields. But in the current economic situation of uncertainty and global crisis, the relationship between the yield curve and information it provides about the future activity has broken down. A steep upward sloping curve during the first half of November is likely to be a result of increased risk aversion to long term lending and flight to safety towards short term securities. To the extent that the long-term bank credit is linked to the 10-year g-sec rates, it is critical that long-term yields come down from their present level. There is some evidence in the second half of November that the demand for long-dated g-sec have increased and the 10-year yields are expected to decline in the near future. In fact, by November 19th the 10-year yield had fallen further to 7.4 per cent although the 1-year yield also dropped significantly to 6.43 per cent. Conclusion It is clear that the monetary policy transmission, as reflected in the yield curve, seems to be working. Both the short and long term rates 20

5 have increased and declined largely in line with the policy changes, indicating the increased effectiveness of the policy actions. As the RBI tightened the monetary policy in times of high inflation and inflationary expectations, with further tightening expected in future, the g-sec yields for both 1 and 10 year rose. Besides, in a high inflation scenario, the term premium rises. On the contrary, a cut in policy rates results in softening of yields with economic uncertainty giving rise to a flat yield curve. Currently, as of mid-november, the market is witnessing a steep yield curve contrary to expectations. Clearly, government securities prices, like other asset prices, incorporate a great deal of information that is relevant to policymakers. However, the information is not always easy to extract and gives ambiguous signals, particularly when the bond markets are immature. 21