An inverted US Treasury yield curve: what does it mean for Bangladesh?

The largest economy in the world, the United States, is showing some unusual trends for both itself and the rest of the world. The US economy encroaches on practically every part of the global economy, altering the course of other economies in tandem with their own. Bangladesh, as a country with a greater reliance on the Western economy, may also be affected by the inverted Treasury yield curve in the United States.

A yield curve is a graphical representation of how interest rates vary with different maturities of securities when looked at over a single moment in time. When long-term interest rates surpass short-term interest rates, yield curves often have an upward slope (i.e., a rising yield curve). However, the United States Treasury yields began to form an inverse curve in the fourth quarter of 2022, which continued in the first and second quarters of this year. 

It began to generate the deepest inverted curve since 1981, the beginning of May 2023, with a substantial gap between the yield on short-term Treasury securities (typically up to one year) and long-term Treasury securities. Because of their term to maturity and other characteristics, long-term Treasury instruments such as bonds and notes often have higher interest rates than short-term securities such as T-bills. However, the current yield curve for US Treasury securities depicts the opposite scenario. 

On May 1, 2023, the US Department of Treasury plotted the daily treasury par yield curve rate for 3-month security and 10-year security at 5.27% and 3.59%, respectively. At the end of the first quarter of 2023, the yield curve rate for the same maturity holding securities was 4.85% and 3.88%, respectively, and at the end of the fourth quarter of 2022, it was 4.42% and 3.88%, respectively. 

The current 3-month Treasury security rate is significantly higher than 5.19% in 2007, right before the global financial crisis. According to the situation, the US Treasury rate is gradually growing for short-term investments while lowering for long-term securities, and the difference between the two is gradually widening.

Why is that so? 

The post-pandemic monetary policy ease, currency printing, US-China economic tension, detrimental global supply chain due to China's shut-down, and the Russia-Ukraine war have inevitably increased inflation in the US market, even though the Federal Reserve System hiked the policy rate to a record level to control the inflation surge. 

In May 2023, the Federal Reserve further hiked the fed fund rate by 25 basis points to 5.25%, implying that private sector borrowing costs could rise to 6.5%–7%. The Fed's record number of rate revisions in the last 12 months is the most in the last four decades to keep inflation below the Fed's target rate. 

According to the Federal Reserve's Monetary Policy Report for March 2023, the inflation rate fell to 5.4% at the start of 2023 from 7% the previous year. However, it remains above the Fed's target rate of 2%. As a result, the policy rate change and FOMC (Federal Open Market Committee) action may not be complete. The report also hinted at the Fed's aim of continuing to tighten the broad money supply (M2).

The Fed's extremely busy office hours have significantly influenced the US economy, and investors and borrowers are closely monitoring the situation. According to the Bureau of Economic Analysis's (USA) "advance" estimate, the US economy managed to grow its GDP at an annual rate of 1.1% in the first quarter of 2023, which is a significant decrease (57.69%) from the pace of 2.6% in the previous quarter. 

The real GDP growth in the first quarter was far below the US government's budget for the fiscal year 2023, 2.8% year on year, and also far below the IMF's annual projection for Western Hemisphere economies (the US) in its current release of the world economic outlook in April 2023, 1.6%.

What does an inverted yield curve indicate?

A yield curve that slopes upward usually suggests robust economic development, a higher interest rate, higher inflation, and a higher employment rate. The inverted yield curve, on the other hand, indicates a recession in the near term, ranging from six months to two years.

When the yield curve begins to form an inverse shape, implying an increase in short-term Treasury security rates, investors get concerned about a rise in market interest rates, eventually raising the cost of borrowing. The greater business borrowing cost harms the economy in various ways, including a higher loan default rate, delaying the establishment of new enterprises, raising unemployment, and so on.

The US Treasury yield curve is continuing to invert as the Fed proclaims that it may hike the policy rate further to keep inflation at what is necessary.

How do you trace an economic recession?

A recession is a significant, widespread, and prolonged downturn in economic activity. A common rule of thumb is that two consecutive quarters of negative Gross Domestic Product (GDP) growth mean recession, although more complex formulas are also used. Negative GDP growth can be caused by higher interest rates in an economy, a loss of consumer confidence, negative external pressure, and other factors.

Economists at the National Bureau of Economic Research (NBER), USA, measure recessions by looking at nonfarm payrolls, industrial production, and retail sales, among other indicators, going far beyond the simpler (although not as accurate) two-quarters of negative GDP measure.

An inverted Treasury yield curve, which indicates impending economic hardship with negative GDP growth, is the strongest sign of an economic recession. The US Treasury yield curve has recently flashed a recession warning for the economy. Since 1955, the US economy has had about ten recessions, each preceded by a yield curve inversion. This distinct pattern reflects investors' lack of confidence due to their concern about deteriorating economic growth.

Impact of yield curve inversion on the private sector

The cost of borrowing in the private sector is substantially higher than that of government treasury securities since it incorporates credit default risk, liquidity risk, term to maturity, and so on. Banks, a major source of loanable funds in the economy, collect short-term deposits and invest them in long-term avenues. 

As a result of the inverted US Treasury yield curve, the costs of funds for banks and other financial institutions for short-term deposit and non-deposit borrowing will rise. So as to charge higher interest rates to their borrowing clients.

The bottom line is that consumer and commercial finance costs would skyrocket, limiting economic progress.

What impact could Bangladesh face? 

An inverted US Treasury yield curve might have far-reaching consequences for Bangladesh. The rising interest rate in the US market made the USD more expensive for the rest of the globe, including Bangladesh. 

Large firms in Bangladesh that previously relied on dollar-denominated loan facilities from outside the country may find it difficult to borrow in USD. The current pattern points to a mild to severe, extended recession in the United States, which may spread further around the world. 

According to the Bangladesh Bureau of Statistics, point-to-point inflation stood at 9.33% at the end of March 2023, with the monthly average (twelve months) standing at 8.39%, despite being planned at 5.6% in the fiscal year budget 2022-2023. 

As a result, controlling inflation in the coming days is unavoidable, and increasing market interest could be a predicted step by the Bangladesh Bank. Furthermore, the central bank has previously signalled that the single-digit lending cap for commercial banks may be lifted, raising borrowing prices for consumers and business borrowers. Private sector growth may be hampered in order to strike a balance between economic growth and inflation control.

Generally, the consumption of people used to decline during recessionary periods, and the reduced consumption by the US market may hurt the RMG export trend of Bangladesh in that market. Furthermore, if the negative GDP growth in the US market persists, it may soon expand to the Eurozone, Bangladesh's largest RMG export market.

As previously said, the US Treasury yield has begun to form an inverse pattern since last Q4 2022, and Bangladesh's RMG export to the US market has decreased from 2.45 billion in Q3 2022, to 2.16 billion in Q4-2022, according to Bangladesh Bank statistics.

Bangladesh's real GDP growth may slow if the US economy enters a recession. Along with RMG export earnings, Bangladesh's GDP development depends on overseas remittances and foreign direct investment (FDI). Furthermore, fluctuations in global commodity market prices may be another source of economic hardship for many countries, such as Bangladesh. 

As the major source of remittances for Bangladeshi workers in the Middle East, the inflow of remittances may decline, negatively impacting the foreign currency reserve. The IMF's April 2023 world economic outlook anticipated 2.9% real GDP growth for the Middle East and Central Asia in 2023, compared to 5.3% in 2022. It should be noted that the Bangladesh Bank stated wage earner remittances of USD 1.68 billion in April 2023, the lowest in 2023 and a 16.28% decrease from April 2022.

Furthermore, FDI growth decreased from its upward trend in Q4-2022, falling 36.02% from Q3-2022. However, Bangladesh received a total of USD 3.48 billion (net) in 2022, which is 20.18% more than the amount received in 2021. The concern here is that FDI inflows may continue to fall as a result of any unfavourable event in the global economy.

What should we care about? 

An alarming worldwide recessionary symptom necessitates a rigorous examination of all economic factors and quick adaptation to the trends. Policymakers must keep the balance between economic growth and inflation in mind. Higher private sector borrowing costs might hinder GDP growth, while rising inflation undermines consumers' purchasing power for essentials. 

It is high time for policymakers to exercise extreme caution when it comes to public spending, which may necessitate the designation of priority sectors. Furthermore, a cautious approach with an end-to-end cost-benefit analysis is essential for any type of foreign debt, and a plan for upcoming foreign debt servicing should be prepared. Hence, it is essential to remember the changes in global economic key indicators in upcoming fiscal and monetary policies.

Undoubtedly, the dollar crisis would be the centre of concern. As such, all strategic partners recommend diversifying export earnings and remittance inflow. Policy support, besides RMG, is essential for the freelancing industry to flourish, broadening remittance-earning countries from the Middle East to other regions of the world. 

Finding new suitable workplaces for engineering graduates outside the country, such as in Singapore, Hong Kong, Taiwan, Korea, the Philippines, and so on, rather than appointing them in public administration, could be another potential source of higher remittance earnings.

Besides, the focus must be placed on the drainage of foreign currency by establishing import substitution production. Moreover, this is the right time to make an all-out effort to attract FDI through policy relaxation, tax incentives, and, more importantly, decreasing the application processing time and company set-up time to persuade investors.

Syed Nazmul Hossain is a banker who got CIPA and CSAA certifications from Bahrain-based AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions), and he is an adjunct faculty member of a top-ranked private university in Bangladesh.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.