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As we explained in our previous article Seeking an interest rate solution, real interest rates are negative and nominal short term interest rates are near zero. That is not healthy. What is a healthy interest rate? My view is that short term rates should be above 1% to make them positive and closer to 2%.

Of course, banks would argue that a healthy spread is the key to a healthy banking sector. Raising the rate would likely flatten the yield curve.

Banks, and many hedge funds make money off the yield curve. They have assets with a higher duration than their liabilities. Although banks fund their assets with a mix of checking, demand deposits and some longer dated term deposits (CDs), they have the ability to swap out longer term deposits (CDs) to make their liabilities duration almost zero. Since the yield curve almost always slopes upward, they can and do make money off that spread.

In 2008, I did some modeling for a large financial institution that had duration of liabilities of roughly 3.5 years, based upon mostly term deposits. They were able to bring the duration on their entire liabilities portfolio down to a duration of less than 0.25 (3 months) by transacting a simple fixed for floating amortizing swap based upon their CD maturity schedule. Every quarter, with the 3 month rate sunk below 25 bps, we would receive a large cash settlement from our investment bank counterparty. I didn't stick for the full term of the swap, but on a 1.5 BB principal, our estimate of earnings from the swap alone stood at $100MM over three years. Based upon where short term rates have stayed, they could have made 1.5 times that.

With our cost of capital below 25 bps, we did the thing that any rational person would do, buy Treasuries. In this case, the 5-year yields were above 2% bringing our expected risk free spread above 2 points.

In 2008 and 2009, when it became obvious that Bernanke would likely leave short-term rates low for an extended period of time, yield curve risk became an afterthought. Those actions have been largely vindicated. If we held the Treasuries for at least three years, the term of the swap, we would just sit back and make money off the spread without having to originate a single loan.

We get to be a bank, without having to do any work to originate loans. Who needs a large origination group, when you can make a ton of money and fire half of your employees?

Pushed or Pulled into Treasuries

During the recession there was often talk of a flight to quality. Investors would flee risky assets and go into something safe. There is much of that, however, investors are not always being pushed, they are often pulled. During the recession, we began seeing a very steep yield curve. The spread investors are as much lured by the allure of easy money with a steep yield curve as they are by the fear of risky assets.

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You can see that the spread: Just parking your money in Treasuries from the beginning of 2008 all throughout 2009 and most of 2010 has yielded the same spread as AAA and almost BAA lending throughout much of the 1990s. The point is that a 2% yield is respectable. To be able to do that with almost no credit risk and fewer employees is enviable.

Which way do I punt?

The nominal spread cannot be looked at by itself in a vacuum. On a nominal spread basis, the difference between the 3 month and the 5-year was near historically high levels. However, because the short term rates were so low, it made the spread much more attractive, and brought the 5-year at almost 20 times the interest rate on the three month.

Click to enlarge:

The spikes you see are for months where the reported price is effectively zero. The closer the short term rates are, the greater that spike is going to be. It is clear to see that these rates are not the norm.

That is important because a primarily long only investor, like a bond fund or a pension fund, might find it attractive (given the outlook on interest rates) to borrow and invest and capture that spread. Taking some yield curve risk and capturing a small nominal spread becomes more attractive as the nominal yield on the long bond falls. A 2% nominal spread to juice up returns is more attractive when the long rate is 3% than when it is 10%

Why invest in risky assets if we can make money on the risk free?

That's why it is almost impossible to cure the credit market when there is the combination of a steep yield curve with rates near zero. Why originate loans at all if you can get almost the same spread as you used to get just by buying Treasuries? You get the added bonus of no credit risk and little overhead?

That's where the Fed's decision to keep rates ultra-low on the short end affect a bank's lending decisions on the long end. The question of why banks are not lending cannot be answered until the ultra-steep yield curve comes down.

The Fed's current approach to flatten the yield curve is misguided. Short term rates are still negative and still causes distortions and too little savings. Raising short term rates would be a better way to flatten the curve.

If we did have higher short term interest rates, there would likely be an increase in capital at savings and checking accounts, because people, of course, respond to incentives. With banks having to invest additional capital, the marginal money would be more likely placed into riskier assets considering the yield curve spread would likely shrink. That would increase lending, which solves why banks aren't lending much in the first place.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Why the Fed Should Raise Rates to Get Banks Lending Again