Inverted yield curve points to a possible recession - KCB

Yields on short-term state instruments are rising faster, outpacing returns on long-term bonds, an unusual phenomenon, pointing to a possible recession in Kenya.

KCB Group in the latest economic outlook released Wednesday says the steepening of the spread between long-term maturities and short-term papers has led to an inverted yield curve since the beginning of HY 2023.

Although the average yield curve rose by 2.61 percent in 2023, yields on short-term local debt are rising by a higher rate of up to 12.6 percent compared to long-term ones that are rising by less than two percent. 

A comparison of yield rate growth on select securities below five years by KCB shows they rose by an average of 7.8 percent year to date compared to an average rise in yields of 1.8 percent for long-term bonds of 10 to 25 years. 

For instance, a year-long bond whose yield was at 10.31 percent is currently trading at 15.79 percent. Another one with a four-year tenure as of December 8 is currently trading at 17.97 percent, having gained a massive 13 percent. 

This contrasts with, for instance, a 20-year bond whose yields have risen by a paltry 1.72 percent in a year. 

Furthermore, the yield on the 91-day Treasury Bill has raced ahead of the 182-day T-bill, signaling heightened investor concern over the government’s near-term fiscal position in a tough economic climate.

The rare inversion on the shortest end of the government’s yield curve leaves the Treasury facing elevated finance costs in the short term, given that the performance levels of the 91-day have outstripped the six-month and one-year papers.

The rate on the 91-day T-bill has jumped to its highest level since November 2015, while those on the 182 and 364-day papers are at levels last seen in February 2016.

According to this week's T-Bill trading results released by the Central Bank of Kenya, all are now trading above 16 percent.

"Guided by the expectations theory of finance, yield curve inversion is a predictor/leading indicator to recessionary periods,'' the report reads.

The lender therefore expects credit conditions to be tightened in 2024, particularly in H1, with additional directed capital to fixed-income securities and continued elevated rates. 

Kenyan banks are holding up to sH1.59 trillion ($10.7 billion) worth of Treasury bonds that are at risk of losing significant value as a result of the high-interest rate regime sustained by the government’s increased borrowing from the domestic market.

Financial experts are worried that this could impact liquidity and the ability of the lenders to meet maturing debt obligations.

When interest rates go up, the value of bonds goes down, and bondholders’ wealth goes down.

According to CBK, banks reported bond revaluation losses on two- and 20-year Treasury bonds of Sh102.7 billion by mid-last year. 

The CBK estimates that if the average bond yields increase to 18.85 percent and 19.89 percent, under moderate.

Lenders are likely to record unrealised bond valuation losses of Sh154.8 billion under the moderate scenario and Sh208.7 billion under the severe scenario, against the baseline estimates of Sh96 billion.