If the bond yield horizon on government debt is a useful predictor of future economic growth then emerging markets are displaying some disturbing signs for investors already edgy about the state of the global economy. Many economists swear by yield curve analysis in the United States where shifts between short- and long-term Treasury bond rates effectively forecast six of seven recessions since 1969. The temptation is to spin the same analysis to other countries,even if their predictive quality is hampered by less liquid markets. On the face of it at least,their behaviour in emerging economies is causing some concern although analysts say what is in prospect is slower growth not a flirtation with recession. In a normal world,a bond yield curve would slope upwards as short-term interest rates tend to be lower than on longer maturities. But the emerging picture has recently tilted toward a flat or even inverted yield curve,where longer bonds' display a shrinking or negative premium to prompt paper. Historically,this is seen to reflect investors' belief that the long-term economic outlook is poor,with lower growth and inflation,and that yields offered by long-term debt will fall. Both India and Brazil display downward sloping curves while others such as China have flattened,with yield differentials between 2- and 10-year bonds there less than 70 basis points,Thomson Reuters data shows. Compare that to the U.S. curve which despite the recent run of weak data,remains 250 bps steep. The yield curve flattening in emerging markets is a result of an adjustment in growth expectations. We are seeing a slower growth outlook being priced in,said Kieran Curtis,who helps manage $1.4 billion in local currency emerging debt at Aviva. That is happening as emerging central banks step up rate rises to tackle inflation caused by oil and food prices,and by America's zero-interest rate policies. The tightening is taking hold,lowering inflation but also crimping economic growth. Factory growth across the world slowed last month,with Chinese factories expanding at the slowest pace in nine months. And all four big emerging economies - India,China,Brazil and Russia - reported slower first quarter growth this year. Some inflation risk premium is also coming out of the market but I think (the flattening) is more to do with the forward-looking data releases,Curtis said. WORRYING FOR EM AND WORLD Historically,an inverted yield curve signals recession. This was last tested in late 2006 when the U.S. curve inverted - 18 months later,the United States was in recession. Evidence is more ambiguous for the developing world where bond market liquidity is thinner and local state-run banks typically hold a significant proportion of government bonds. Consumers also tend to be less sensitive to rate movements. But with emerging markets accounting for almost three quarters of global economic growth,even a modest slowdown will reverberate through the world economy and financial markets. It was headlong growth in China and to some extent India,that drove the recent commodity boom and it was their resilience that cushioned the impact of the 2008 financial crisis. Above all,a slowdown spells bad news for the hundreds of billions of dollars in investment that has been bet on rapid growth in the developing world driving equity returns. Flat yield curves are an ominous signal for equities - they hinder lending to the economy and bank profits for instance as banks cannot charge higher interest rates on longer-term loans. No wonder,India and Brazil,with more policy tightening to come,have two of the worst-performing stock markets this year. The yield curve gives you a very good indication of how attractive a market is for equities,said Michael Penn,global equity strategist at Bank of America/Merrill Lynch. The Indian yield curve is flat and almost inverted and a negative yield curve is very bad for equities. NO RECESSION India is the market analysts worry most about,especially after growth in January-March 2011 fell to a five-quarter low. Like much of the emerging world,Indian policy was loose for too long - real interest rates stayed negative for 31 months,according to Lombard Street Research,which last week predicted a violent growth downswing by year-end. Rashique Rahman,head of EM macro strategy at Morgan Stanley says that while flat curves in Brazil or China are more about moderating inflation than growth,the opposite is true in India. So,how much of a slowdown can be expected? While Indian 2011 growth was originally forecast at 9 percent,Lombard Street now predicts a slowdown to 6-1/2 percent this year. Most other analysts expect around 7.5 percent. The EM curves are not signalling a sharp slowdown per se but the challenge going forward may increasingly be in managing the slowdown,Rahman said. That's in the mind of the market. Chinese growth,for all the fears,may slow to 8-9 percent per annum. Brazil,which grew 7.5 percent last year is expected to slow to around 4 percent next year. Hardly a recession then. But as BoA/Merrill analysts put it,what's in the cards could be a slow motion slowdown.
