U-turn in the yield curve

Interest rate volatility is nothing new in Pakistan. Between 2005-2008, discount rate moved between 7.5 percent to 15 percent. And the policy rate was down to 5.75 percent (discount rate: 6.25%) in 2016. It increased back to 13.25 percent (discount rate: 13.75%) in 2019 and is now at 7 percent (discount rate: 8%). Some volatility is healthy; but not too much.

SBP should come up with a mechanism to reduce the volatility in interest rates for businesses to make long term financing decisions comfortable. The other element is that exchange rate (fixed or flexible) remains volatile too. There is a trade-off between interest rates and exchange rate in an economy such as Pakistan. Thus, interest rates must be stable for a steady outlook on exchange rate.

This has a linkage with the yield curve which shifts quicker in time from inversions to upward sloping. In October 2019, secondary yield of 3M paper was 13.3 percent, and 10-year was at 11.3 percent. There was a case of inversion in the yield curve – from 12-M to 10-Y bonds. Now on 8th July 2020, the 3M is yielding at 6.6 percent and 10-year bond is at 8.7 percent – the yield curve is upward sloping –from 12-M to 10-Y.

This U-turn in the yield curve is plausible. A similar shift was witnessed between 2009 and 2016. However, the shift this time has accelerated due to COVID – else the pattern is the same. Without delving into the theory of recession in downward sloping, and boom in upward sloping yield curve, common sense says that when the short term rates are so volatile (and move in band of 6-15 percent), long term bonds ought to be in the middle somewhere. In days of low policy rates, long term bonds must be higher and vice versa.

Now connect this to the maturity profile of the government debt. The maturity profile of Pakistan’s domestic debt is low. There is (almost) always pressure from the IMF whenever we are in Fund’s programme. It is best to secure long term fixed rate borrowing when the short-term rates are low. Long term bonds look expensive on that very day – as yield curve is upward sloping, but in broader spectrum they are cheap.

For instance, the ministry of finance should now increase its holding in long term PIBs at around 8.5-9 percent as much as it can. Short term rates are close to their historic bottom. It is best time to take position in long term bonds even though they appear to be expensive in today’s rate. Lately, debt office in ministry of finance is opting for floating bonds – but floating bonds are best to offer in days when rates are high. These days, the target should be more on fixed rates to milk during the low rates days.

However, the premium should not be insane like it was during Dar’s time in 2014 – by issuing long term bonds worth Rs2 trillion at 4 percent premium to the short term. Last year, the ministry took exposure in long term bonds at peaking rate of (13-14%) of amount Rs1 trillion mainly in 3-year paper. Now it is time to lock in long term bonds. But there is always a pressure to not do so – some ex-officials tweeted on government exposure of around Rs100 billion in long term last month. Debt office should overlook such comments and do what is rightful.