Yield curves across the market segments have been flat to inverted over the last one-and-a-half years on the back of tight liquidity conditions and policy rate hikes.

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The normal shape of the yield curve is upward sloping where long maturity bond yields are higher than short maturity bond yields.

An upward sloping yield curve reflects a strengthening economy while flat to inverted yield curves reflect weakening economy.

A flat to inverted yield curve largely expects economic growth to fall and the central bank to ease monetary policy in the face of falling growth expectations. The weak growth expectations also bring down or stabilise inflation expectations.

The 25 basis points (bps) cash reserve ratio (CRR) cut by the RBI in its mid-quarter policy review on Monday is a signal for yield curves to start steepening as markets factor in easier liquidity conditions and repo rate cuts down the line.

The current levels on government bonds, corporate bonds and interest rate swaps are still in a tight liquidity and high policy rate mode.

One-, five- and ten-year government bond yields are trading at 8%, 8.20% and 8.18% levels, respectively, while one-, five- and ten-year corporate bond yields are trading at 9%, 9.15% and 9.20% levels. One- and five-year overnight index swaps (OIS) yields are at trading 7.7% and 7.15% levels respectively.

The difference between one- and ten-year yields in both the government bond and corporate bond yield curve is just around 20 bps and this flat spread will widen, going forward. The difference between the one- and five-year OIS yield is a negative 55 bps and this inversion will come off down the line.

The 25 bps CRR cut will infuse Rs17,000 crore of liquidity into the system. The RBI cut CRR on expectations of liquidity tightening in October on the back of credit growing and  money going out of the system due to festive season demand for cash. Liquidity conditions are looking much better than what they were six months back with banks’ demand for daily funds from the RBI coming off by around Rs60,000 crore.

Weak incremental credit deposit ratio (ICDR) at 25% this fiscal so far, trade deficit that is down 6.6% in the first five months of this fiscal, positive portfolio flows into equity and debt, and Rs80,000 crore of bond purchases by the RBI have helped liquidity.

Liquidity conditions can turn positive down the line if the trend of weak credit growth, falling trade balance and positive portfolio flows continue.

In its policy review statement, the RBI  has said that it will look closely at the weakening growth expectations – private economists are forecasting India 2012-13 GDP growth to be 5.5%, lower than RBI estimates of 6.5%. The RBI’s response to slowing growth will be much less aggressive than what it was at the time of the 2008 credit crisis.

At that time, the RBI brought down repo rates to all-time lows of 4.75% in the wake of the crisis. This time round, the RBI will lower repo rates but in a calibrated manner and in much less quantum. The RBI has indicated that it will reduce repo rates going forward and this will lead to yields at the short end of the curve coming off.

A steepening yield curve signals more policy action to spur growth, and that will lead to positive sentiment in equity, currency and bond markets.