Inverted US yield curve no more a worry for markets; here's why

The current yield inversion has more to do with the temporary demand-supply mismatch in the bond market and doesn't necessarily signal a recession in the US

Global equity markets are showing resilience to the yield curve inversion in the US -- a phenomenon where the yields on longer tenure bonds fall below those of shorter tenure bonds. Over the past one week, the Dow Jones and S&P 500 have rallied 2 per cent and over 3 per cent, respectively, while domestic S&P BSE Sensex and the Nifty50 have added 1 per cent each.

This is despite the yield on the two-year treasury bond climbing higher than that of the 10-year bond, bringing the spread down to negative briefly on Wednesday. Earlier, on Monday, the five-year bond yield exceeded that of the 30-year bond yield, the first time since 2006. Historically, every yield inversion in the US since 1955, except in 1990, has been followed by a recession.

However, analysts say, the current yield inversion has more to do with the temporary demand-supply mismatch in the bond market and doesn't necessarily signal a recession.

According to Joydeep Sen, an independent debt market analyst, the current yield inversion is due to the massive bond purchases by the US Fed to fight the Covid-19 induced slowdown, depressing long-dated yields relative to shorter-dated.

"Whenever the US Fed will hike the interest rates, there will be pessimism in the bond market. If the selling in shorter tenure bonds is more than longer tenure bonds, the inversion will stay as prices of shorter tenure bonds will fall. Hence, this inversion is due to temporary demand-supply mismatch," he says.

Nitin Raheja, Head- Discretionary Equities, at Julius Baer adds that another part of the yield curve - the yield on three-month-10-year treasury - monitored by the US Fed as a recession indicator remains far from inversion and is trending at 184 bps currently," he says.

The shape of the yield curve is a key metric investors watch as it impacts other asset prices, feeds through to banks' returns, and has been an indicator of how the economy will fare.

Normally, the yield curve slopes upwards because investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds. An inverted yield curve, meanwhile, implies that investors are willing to forgo higher returns for holding bonds longer. This is because they believe that the economic growth is likely to lose steam in the medium-term.

Fears of a slowdown in the US economy are growing amid the on-going geopolitical tensions between Russia and Ukraine, aggressive rate hikes by a hawkish US Federal Reserve, and expected reduction in its balance sheet. Yet, analysts say the US economy is not eyeing recession.

"As of now, most parameters do not indicate any kind of recession in the US but the growth may start to fall towards the long term trend line of 2 per cent by 2023," says Piyush Garg, Chief Investment Officer at ICICI Securities.

Investment strategy

Vineet Bagri, Managing Partner, at TrustPlutus Wealth, says India remains a growth market with swift recoveries. There is very little chance for investors to fish at the bottom, thus it is better to stay invested and follow asset allocation matrix.

"The Indian markets have borne the brunt of FPI selling over the last many months, reflecting the fears of Central Bank tapering policies and possible rate hikes. If the US economy were to hit a recession we believe most of these outflows would have been front loaded and wouldn’t incrementally impact the Indian markets. Further India remains a domestic consumption-oriented economy which except for a few export oriented sectors would remain largely insulated," Raheja adds.

"Investors with an investment horizon of at least five years, should consider investing at the long-end of the yield curve in order to benefit from recent elevated yields and potential price appreciation," says Dhawal Dalal,CIO-Fixed Income, Edelweiss MF.