As the new year approaches, several of the world’s top economies, including the United States, are facing fears of recession. One of the most crucial indicators, suggesting a downturn for such economies is the inversion of US treasury yields.
Understanding Recession
Typically, a recession involves an overall output contraction in an economy for at least two successive quarters, accompanied by job losses and a decrease in overall demand. Whether or not an economy is in a recession is determined by the US National Bureau of Economic Research (NBER), based on their assessment of the depth, duration, and diffusion of the economic impact. Sometimes, the duration may not be long but the decline could be severe, such as the recent Covid-19 pandemic, or the depth and diffusion may be less, but the downturn may last longer, as is expected post the United Kingdom’s economic crisis.
US Treasuries: A Brief Overview
In any given economy, the safest loans are those that are allocated to governments since they seldom default on their debt. The instrument used for governments to borrow from the market is known as a government bond. These bonds have different names in different countries: G-secs in India, gilts in the UK, and treasuries in the US.
Yield of a Treasury Explained
Unlike bank loans, where interest rates vary over time, government bonds come with a pre-determined “coupon” payment. For instance, a 10-year US government bond with a face value of USD 100 and a coupon payment of USD 5 would imply a yield of 5%. However, if this bond is sold to another investor, the yield will change depending on the price at which the bond is sold.
Understanding the Yield Curve
Governments borrow money for durations ranging from one month to thirty years. Yields are typically higher for longer tenures, and when mapped, these give rise to an upward-sloping curve called the yield curve. This curve can be flat or steep depending on the money availability in the market and the expected overall economic activities.
Yield Inversion: A Predictor of Recession
Yield inversion occurs when the yields for shorter duration bonds are higher than those on longer duration bonds. This phenomenon has long been a reliable predictor of a recession in the US and has been witnessed with US treasuries for some time now. This is evidenced by the spread between the yields of 10-year and 3-month treasuries turning negative.
Recession Implications for India
A US recession implications could lead to a stronger US dollar against the rupee, making imports more expensive and potentially fuelling domestic inflation in India. The higher returns in the US may also result in a rebalancing of investments coming to India. Although a weaker rupee could benefit Indian exports, a recession would dampen the demand for Indian exports.
Dealing With Economic Recession
During an economic recession, steps are usually taken to increase the money supply in the economy. Expansionary Monetary Policy can be implemented to increase the supply of money, thus promoting economic activity and expenditure. An increase in expenditure on public projects could also help in bringing a country out of economic recession.
Understanding the indicators of an economic recession, such as the yield curve inversion, is crucial for countries worldwide. It helps governments take necessary pre-emptive measures to safeguard their economies against the potential adverse effects of a recession. As we move into the new year, it remains vital for economies to monitor these signs closely and strategize accordingly.
