Thematic Research – Term Structure of Interest Rates & Growth

Economic Intelligence Cell

Term Structure of Interest Rates & Growth

4th January 2024

The level of the yield curve measures the general level of

interest rates in the economy and is greatly influenced by the
policy rate. Slope of the yield curve is considered to be a
leading indicator of future economic growth and inflation. An
upward sloping yield curve indicates economic optimism and Deepak Singh, Chief Economist
therefore, higher interest rates. [email protected]

Types of Yield Curves

Harshita Panda, Economist
The slope of the yield curve reflects the difference between yields on [email protected]
short-term bonds and long-term bonds.

Normal Yield Curve: A normal shape for the yield curve is where
short-term yields are lower than long-term yields, so the yield curve is
convex upwards. A normal yield curve is often observed in times of
economic expansion, when economic growth and inflation are
increasing. In an expansion there is a greater likelihood that future
interest rates will be higher than current interest rates, because
investors will expect the central bank to raise its policy interest rate in
response to higher inflation.

Inverted Yield Curve: An inverted yield curve is where short-term yields are higher than long-
term yields, so the yield curve is concave downwards. An inverted yield curve has historically been
associated with preceding an economic contraction as central banks reduce policy rates in
response to lower economic growth and inflation, which investors may anticipate will happen.

Flat Yield Curve: A flat yield curve occurs when short-term yields are similar to long-term yields.
A flat yield curve is typically an indication that investors and traders are uncertain about the
macroeconomic outlook. Yield curve flattening is often observed during transitions between
normal and inverted curves.

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Thematic Research – Term Structure of Interest Rates & Growth
Economic Intelligence Cell
Analysis of Yield Curve & Growth Relationship
Chart 1: Yield Curve of the United States (Present, 2 years ago & 5 years ago)

Source: Cogencis

Chart 2: United States Annual GDP Growth (%)

8.00
5.95
6.00

4.00 2.95
2.28 2.29 2.71 2.24 2.30
1.84 1.67 2.07
2.00

0.00

-2.00
-2.77
-4.00
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Note: Year Indicates calendar year Source: Cogencis

 The yield curve for the US economy presently (deep blue curve in chart 1) has the highest
yield at the lowest maturity which gradually falls as maturity increases. This is apparent as the
Federal Reserve had been increasing the policy rate up till July 2023.
 At longer maturities the curve gradually flattens out- reflecting uncertainty on the part of market
participants as the Fed has indicated a neutral stance going ahead in its recent monetary policy
announcement, although the probability of a policy rate cut remains high. This is also evident
in the GDP growth rate of the US economy which is observed to be returning to its long-term
trajectory after the post-pandemic jump.
 The present yield curve is also mirroring the 2 years ago yield curve (black curve in Chart 1)
when the Fed was cutting rates in response to the COVID-19 pandemic. The 2 years ago curve
displays expectations of an immediate recession with a prolonged recovery (the curve
gradually flattens out at higher maturities). The present curve has also shifted upwards in
comparison to the 2 years ago curve in response to Fed’s rate hikes.

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Thematic Research – Term Structure of Interest Rates & Growth
Economic Intelligence Cell
 Similar pattern can be observed in the UK economy as well.
Chart 3: Yield Curve of the United Kingdom (Present, 2 years ago & 5 years ago)

Source: Cogencis

Chart 4: United Kingdom Annual GDP Growth (%)

10.00 7.60
8.00
6.00 4.00
3.20 2.40
4.00 1.80 2.20 2.40
1.40 1.70 1.60
2.00
0.00
-2.00
-4.00
-6.00
-8.00
-10.00
-12.00 -11.00
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Note: Year Indicates calendar year Source: Cogencis

Chart 5: Yield Curve of India (Present, 2 years ago & 3 years ago)

Source: Cogencis

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Thematic Research – Term Structure of Interest Rates & Growth
Economic Intelligence Cell
Chart 6: India Annual GDP Growth (%)

12.00
9.05
10.00 8.26
7.41 8.00 6.80 7.24
8.00 6.39 6.45
5.46
6.00 3.87
4.00
2.00
0.00
-2.00
-4.00
-6.00
-5.83
-8.00
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Note: Year Indicates fiscal year. E.g. 2022 stands for FY2022-23 Source: Cogencis

 In case of India as well, a similar trend is observed. Present yield curve (black curve in chart
5) shifts up from the 2 year ago curve (deep blue curve in chart 5) indicating an upward shift
in interest rate expectations in response to monetary tightening by the RBI post the pandemic.
 The present yield curve gradually flattens out although it appears to be upward sloping-
reflecting uncertainty as the RBI has resolved to maintain status quo on interest rates.
Although, with a change in the Fed’s stance, the RBI may follow suit.
 The 2 year ago curve is normal at shorter maturities indicating a recovery from the COVID-19
pandemic, while it inverts at longer maturities and later flattens out- indicating expectations of
rate cut in the long term as growth gradually tapers.
 The 2 year ago curve is also above the 3 year ago curve (light blue curve in chart 5) as growth
in the Indian economy had started faltering even before the COVID-19 pandemic (see chart
6).
Conclusion
 Growth rates as well as interest rates in the Indian economy are presently on an uptrend (and
significantly higher) compared to those in advanced economies.
 The economy’s near to medium term outlook is therefore favourable for foreign fund inflows
(FDI/ FII), currency stability and forex reserve position.
 Adverse movements in the USD/INR exchange rate are likely to be arrested as a result.
 GDP growth numbers are expected to be on the upside going forward.

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Thematic Research – Term Structure of Interest Rates & Growth
Economic Intelligence Cell

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