The sovereign bond yield curve in several emerging market countries has been inverted. This means that the yield on shorter maturity notes is higher than on longer-maturity notes and bonds. In a benign economic environment, a yield curve typically slopes upwards as yields rise with an increase in maturity.

An inverted yield curve is widely considered to be a signal for recession. In the US, this occurrence has been an accurate predictor of the previous two recessions. The graph above shows US Treasuries yield curves several months before recession hit the economy in 2000 and 2006.

While a central bank influences the short-end of the yield curve via its key interest rate, inflation generally determines the long-end of the curve. If the central bank is on a rate hiking spree – a sign of an economy getting stronger and risking a spike in inflation – then the move pushes yields on short-maturity papers.

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However, if market participants have lower inflation expectations than the central bank does, yields on longer-term papers decline as investors move to shorter-duration papers. This leads to an inverted yield curve and is also considered a cautionary tale for equity investors.

The graph above shows the yield curves of Mexico, India, and China as of June 28. The curves of the first two are plotted with the left or primary Y-axis while that of China is with reference to the right or secondary Y-axis. At different points, there are tenures which have lower yields than their previous ones.

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Turkey also finds itself in a similar situation.

Strong stock market performance

The graph above shows the returns of the MSCI indices corresponding to these countries through June 28. For countries experiencing inverted yield curves, these are exceptional returns. An exception here is Russia, whose equities have been hammered along side an inverted yield curve with the MSCI Russia Index down by 15.1% through June 28.

In the next article, let’s look at what could be causing this and how this could impact emerging markets going forward.

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