India's Yield Curve Inversion Points To Elevated Rate Hike Expectations

India's first yield curve inversion in eight years points to expectations of higher rate hikes by the monetary policy committee in the near term. Over the last few weeks, India has seen its short-term rates rise much faster than long-term rates.

The inversion happens when the yields on short-term securities end up higher than the longer-dated ones.

According to the latest auction data released by the Reserve Bank of India, the 364-day treasury bill yield cut-off stood at 7.48%, compared to the 10-year benchmark yield which closed at 7.43% on Wednesday. In the three T-bill auctions conducted since Feb. 15, the cut-off yield on the 364 day securities rose by 33 basis points.

The 10-year benchmark yield stayed flat at 7.43% on Thursday as well. While such an inversion has continued in the U.S. for some time now, this is happening for the first time since early 2015 in India, according to data available on Bloomberg. Considered a leading indicator of recession in the developed economies, the inversion is usually not such a perfect indicator in developing economies like India.

"The yield curve inversion points to the fact that there is an expectation of near term rate hikes," said Ajay Manglunia, managing director, JM Financial. "We already have comments from the US Federal Reserve Governor that there might be a need for faster paced and higher quantum rate hikes."

Manglunia said a lack of long-term borrowers and fewer capital investments mean that the longer term rates have remained benign. Tightness in short term liquidity is also driving up rates.

"Short term rates going up are also a sign of liquidity getting tighter. This can be linked to the expected redemption of LTRO/TLTROs (long term repo operations) as well as advance tax payments in the coming week," Madan Sabnavis, chief economist at Bank of Baroda, said. "Market believes now that the RBI will also increase rates. Data on inflation to be released on Monday will be crucial and markets will remain edgy till then."

Manglunia expects a 35 basis-point-hike to the repo rate at the April meet of the monetary policy committee.

The last retail inflation print at 6.52% in January, compared to 5.72% in December, pointed to inflationary pressures persisting for longer than expected. Economists polled by Bloomberg estimate the February consumer price inflation rate to be at 6.4%, continuing above the monetary policy committee's tolerance band of 4% (+/-2%).

During the February meet, the MPC decided to hike the benchmark repo rate by 25 points, without giving any clear indication of the rate hikes it intends to take in the future. While the decision received majority votes within the MPC, two out of the six members objected to it. Jayant Varma and Ashima Goyal both felt that it was time to pause on rate hikes.

According to Varma, there was need to maintain caution amid headwinds to growth. Goyal fears excessive frontloading of rate hikes could lead to the risk of overshooting.