December 2008
EconomyView
Does The Monetary Policy Make The Yield
Curve Move ?
Analytical Contact:
Poonam Manjul
Vidya Mahambare
[email protected]
[email protected]
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 10year government securities. Apart from providing information about
.........
the future state of the economy, the g-sec yield curve serves as an
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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
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expectations of future economic activity or inflation.
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these are largely illiquid, and hence, their yields do not truly reflect
Source: RBI
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
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
short term interest rates in the economy are influenced to a large
largely responded to the changes in the monetary policy since April
extent by the monetary policy changes. The monetary policy actions
2006 (fig 1.2). Monetary tightening, which began in June 2006 with a
also influence market expectations of the future short term rates for
hike in the repo rate, continued till the end of the March 2007, taking
the next couple of years. The interest rates for longer horizon, however,
the repo rate to 7.75 per cent with a cumulative hike of 125 basis
are also influenced by factors other than the policy actions. For example
points. In addition to this, CRR, which was kept unchanged till
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,
December 2006, was hiked by 100 bps during the last 3 months of
2006-07. 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, 2007.
The yield of 10-year paper also kept increasing during this period as is
depends on the extent of real interest rate risk and the inflation risk.
evident in figure 1.2. However, how have the longer-term interest rates
Nonetheless, the long term yields also indicate the market expectations
been behaving as compared to short-term rates during this time can
of the future economic state of the economy. In the following analysis,
be best understood by constructing a very rough yield curve using the
we examine the relationship between the policy, the state of the economy
1-year and 10-year g-sec yields for India (fig 1.3).
and the yield curve in India.
Figure 1.2 : G-Sec Yields and Monetary Policy Rates
During 2006-07, 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
Source: CCIL and RBI
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reducing liquidity.
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Figure 1.3 shows an "upward-sloping" yield curve for April 2006 and
April 2007. 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
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In 2007-08 the yield curve suggested the impending uncertain
economic environment
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The yield curve during 2006-07 suggested faster economic expansion
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Source: RBI and CCIL
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Source: CCIL
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Figure 1.4: Yield Curve Spread and Policy Rates
May-06
Figure 1.3 : Yield Curve on Selected Time Periods
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 2007-08, 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 2007-08, 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 future rate of inflation increases and investors demand higher
The flat curve indicates that the 1-year rate and the future expectations
yields to hold longer maturities. The similar economic environment of
for 1-year forward rates are almost the same. This type of yield curve
period around April 2006 explains the upward sloping curve then.
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
the spread between 1-year yield and 10-year yield widened to more
an economic slowdown. A flat yield curve does not compensate the
than 100 basis points (fig 1.4). The yield curve spread is the difference
bond holder for the additional risk associated with buying a longer
between long-term and short-term interest rates, and is useful in
term to maturity bond. In other words, the term premiun declines during
predicting the performance of an economy. Higher long term interest
such period. To the extent that long-term rates have been influenced by
rates give the financial market an incentive to lend money. Credit
macroeconomic conditions and resulted in the flattening of the yield
expansion, in turn, stimulates economic expansion. Such indeed
curve, the market participants expected the monetary policy to ease
was the economic scenario in 2006-07. However, with liquidity
and interest rates to come down in near future. This might explain the
tightening in the money market, the yield curve flattened with the
flat yield curve during 2007-08, when the inflation in India was at
spread between 1-year and 10-year yields narrowing to 30 basis points
unprecedented low levels and easing of the policy was on cards, if not
at end-March 2006.
for the food and fuel price increases in the following period.
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Steep yield curves were observed in the subsequent few months when
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Yields in the long-term paper hardened in the beginning of 2008-09,
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 2008-09. 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
Source: CCIL
cent during this period. For the next 2 months, while the policy rates
prices. But this period witnessed an inversion in yield curve as the
The 10 - year yield falls less than the 1-year yield following the
policy easing suggesting increased risk aversion
yield of 10-year paper fell below that of 1-year rate (fig 1.5- the yield
The yields of both long-term and short-term g-secs eased in November
curve for Sep 08). The central bank went in for a series of cut in repo
2008 following further loosening of the monetary policy. The short-
rate and CRR in the subsequent months following the global financial
term yields, however, have dropped much more than the 10-year yields.
crisis. Since then, the government securities yields have eased. Over
As a result the yield curve in November 2008 (November 1-15), has
this period, as the graph 6 suggests, the yield curve is almost flat
again upward sloping with the yield spread widening to over 70 bps
again.
(fig 1.3 and 1.5). Generally, whenever investors expect economic
remained unchanged, the yields fell with the softening of crude oil
expansion they shift their money to short-term securities away from
long term bonds. This shift leads to the lowering of short-term yields
slowdown
and an increase in long-term yields. But in the current economic
An inverted yield curve, as experienced in August-September 2008,
situation of uncertainty and global crisis, the relationship between
occurs when long-term yields fall below short-term yields. Historically,
the yield curve and information it provides about the future activity
an inverted curve has indicated a worsening economic situation. In
has broken down. A steep upward sloping curve during the first half of
addition to potentially signaling an economic decline, inverted yield
November is likely to be a result of increased risk aversion to long term
curves also imply that the market believes inflation will remain low.
lending and flight to safety towards short term securities. To the extent
As a result, lower bond yield is offset by low inflation. The global
that the long-term bank credit is linked to the 10-year g-sec rates, it is
financial crisis in the middle of 2008 led to an expectation of
critical that long-term yields come down from their present level. There
worsening of domestic economic situation as well. This may have
is some evidence in the second half of November that the demand for
resulted in an inverted yield curve. The yield curve once again became
long-dated g-sec have increased and the 10-year yields are expected
flat by October 2008 (fig 1.5). Investors seem unsure about the economic
to decline in the near future. In fact, by November 19th the 10-year
conditions in the future. Investors expect economic activity to slow at
yield had fallen further to 7.4 per cent although the 1-year yield also
some point in the future, but are uncertain about its magnitude. If the
dropped significantly to 6.43 per cent.
investors expect that economic weakness requires further policy easing
Conclusion
in the medium term, they mark down their projected path of future
It is clear that the monetary policy transmission, as reflected in the
spot interest rates, causing the yield curve to flatten.
yield curve, seems to be working. Both the short and long term rates
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An inverted yield curve in September 2008 suggests future economic
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have increased and declined largely in line with the policy changes,
a flat yield curve. Currently, as of mid-November, the market is
indicating the increased effectiveness of the policy actions. As the RBI
witnessing a steep yield curve contrary to expectations.
tightened the monetary policy in times of high inflation and
Clearly, government securities prices, like other asset prices, incorporate
the g-sec yields for both 1 and 10 year rose. Besides, in a high inflation
a great deal of information that is relevant to policymakers. However,
scenario, the term premium rises. On the contrary, a cut in policy rates
the information is not always easy to extract and gives ambiguous
results in softening of yields with economic uncertainty giving rise to
signals, particularly when the bond markets are immature.
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inflationary expectations, with further tightening expected in future,
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