beyondbrics

The recent inversion in yield curves in Brazil, India and China, spells trouble, right? It means recession’s on the way, no?

Not really, says UBS’s Jonathan Anderson. He doesn’t see why investors have suddenly started worrying about the fact that short-term interest rates have climbed above long-term in the three biggest BRIC economies. Calm down, he says. Don’t panic.

Anderson writes that “over the past few days” everyone wants to talk about inverted yield curves, prompted by a sudden spike to over 8 per cent in Chinese short-term rates. The FT drew attention to the debate last week under the headline “Wary investors spy trouble in Brazil and India bands” and it was not alone.

Anderson says in a report:

[This] immediately raises questions:  aren’t inverted curves a sign of pending recession, or at least a sharp slowdown ahead? And thus isn’t this a very worrying signal for these large and important EM countries? Our answers are “not really” and “not really”.

Of course, the curves are “clearing telling us” that Brazil, China and India have tightened significantly over the past year and economic activity is slowing. But, says Anderson, they don’t mean “we are facing recession risk or anything close to it”.

Anderson says that, first, the situation is not new since inverted yield curves were common in emerging markets for long periods before the global economic crisis – as this chart of an average of 25 EMs  shows:

Right now, Anderson argues, monetary policy is normalising – with interest rates rising to counter inflation risks.

On top of this, there has be a structural increase in liquidity in local debt markets, fuelled by huge financial inflows from the developed world, which was interrupted by the global crisis but resumed with great force after 2008.  So while central banks are pushing up short-term rates, investors are pulling down long-term rates.

Anderson says:

Small wonder, then, that curves flattened or inverted in 2006-07. And an even smaller wonder that they are back in inverted territory now for those countries that are tightening up the most at the short end.
So again, short-term interest rates are telling us that central banks have tightened in Brazil and India, for example. But by the same token, the long end is not telling us about looming recession and disinflation fears.
Rather, in our view it is telling us something fundamental about local (and foreign) liquidity conditions.

China is a bit of an exception, however. Foreign portfolio investment is limited, interest rates are not generally used to control credit, and the government plays a big role in directing local liquidity and investment flows by making allocations. “I.e there’s no real information content in the long end – and too much volatility at the short end.”

Against Anderson are ranged EM bears warning of trouble ahead. Among them is Richard Bernstein, former chief investment strategist for Merrill Lynch, who now runs his own firm, Richard Bernstein Advisors. He told the FT that he now had less than 2 per cent of his mutual fund invested in emerging market stocks and had no emerging market debt.

Bernstein said: “Governments in Brazil, India and China are caught between a rock and a hard place.”  He noted that if they continued to tighten, they could slow economic growth to a point that was politically unacceptable, but if they did not act, basic items such as food could become unaffordable.

So the jury is out. If you want to join the debate, please add your comment below.

Related reading:
How China plans to reinforce the global recovery, Wen Jiaobao, writing in the FT
Indian inflation rises faster than expected, FT
Opinion: Time to put the southern Silk Road on the map, FT
The end of inflation? Not for long, beyondbrics
Inflation file, beyondbrics