Presaging a bull run

A few months ago,when the yield curve was inverted,we had said in Express Money that an inverted yield curve suggests a slowdown,and that in such times long-term bonds do well. That call has been vindicated as is evident from the stellar returns from long-term bond funds between July 2008 and January 2009. Now,in April 2009,the yield curve looks similar to what it looked like in October 2002. This means that over the next few years we may have another bull market. The latest reverse repo cut may prove to be the last straw that breaks the bears back.

What the yield curve says

Look at the red line,which was how the yield curve looked like in October 2002. Such an upward sloping curve is known as a normal yield curve. It means that if the government wanted to borrow money for 0.02 years the first point,it would have to pay an annualised interest rate of 5.52 per cent. Similarly,if the government borrowed for 20 years,it would have to pay 8.11 per cent per annum. This is known as the yield,or the return that the investor would get for his investment in a government paper of that particular term. This explanation is an extremely simplified one. There can be many finer nuances like Yield To Maturity and Zero Coupon Yield Curve.

If you look at the curve as on 22nd April 2009,there are two startling observations. One,the yield curve has shifted down; and two,it is a normal yield curve. A lower yield curve implies that the cost of borrowing has come down for the government as compared to October 2002. In 2002 the government had to pay,say,7.22 per cent for a 10-year loan; today it has to pay 6.98 per cent. Obviously lower cost of borrowing is good for any borrower.

And a normal yield curve indicates that the economy will chug along nicely in future.

From 2003 to 2008,our economy did indeed grow at a fast pace GDP growth was between 8 and 10 per cent. As the economy grows,companies enjoy higher earnings. As investors local and global anticipate higher earnings,liquidity comes back to the market and stock prices rise.

The current yield curve is even better than in 2002. If you look at the difference between the yields at the long end of the curve yield for 20-year paper was 8.11 per cent in 2002 and is 7.6 per cent now and short end yield for 0.5 year paper was 5.59 per cent in 2002 and is 4.24 per cent now end of the curve,the difference has increased. In October 2002 it was 2.51 per cent whereas today it is 3.35 per cent. Such a yield curve is called a steep yield curve. Steep yield curves are seen at the end of recessions or slowdowns and are harbingers of good times. With the Reserve Bank of India RBI cutting the reverse repo rate in April 2009,banks have even less incentive to park their surplus funds with RBI. This will mean that more money from banks will come into the economy by way of lending to corporates and households. If banks do not lend,liquidity will remain in the system and RBI may put a cap on the money that can be deposited with it. If RBI imposes a cap,short-term rates will come down even further,and this will mean an even steeper yield curve which is highly unlikely. Funds will be available even more cheaply,and thus will begin the virtuous cycle of lending by banks,investment by corporates,consumption by people,and hence growth in the economy.

By ignoring such strong indications and continuing to focus on the slowdown,we would be preparing for history,which is futile. The mistake we could make is to remain out of the market while the Sensex rises to new highs. u

The author is a professional trainer for NISM,BSE and mutual funds.

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