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Steep Yield Curve, Less Lending

|Includes: Citigroup Inc. (C)
Editor's Note: This article originally appeared in Jason Farkas' January 26 "Weekly Insight" column of EWI's intensive Currency and Interest Rate Specialty Service


A steep yield curve is usually a boon for banks, according to traditional economic theory. After all, it allows them to borrow at low rates and lend at higher rates. Some of the largest expansions in U.S. history have come with steep yield curves. But we now have a situation that defies traditional theory. The yield curve has been quite steep for more than a year (chart courtesy of, but bank lending has fallen, not risen.  

The bank credit chart shows that, in fact, bank lending is negative year over year -- something that hasn't happened since 1950.  That's significant, because bank credit growth managed to remain positive even during the recessionary 1970s, the S&L crisis in the 1980s, and the bursting of the tech bubble in the 2000s. Why is it different this time around? Because, in terms of Elliott wave analysis, the size of the economic peak and resulting downturn is at least one degree larger than the previous downturns. Today’s falling social mood has affected bank lending in the following ways:
1.    Risk-Free Returns - Since banks are getting paid by the Fed to hold reserves there, they can guarantee themselves risk-free returns. They have the hope of healing their balance sheets over time, without actually putting their money at risk by lending it to businesses or individuals.
2.    Hidden Losses - Since banks know they have unrealized losses on existing loans,  it makes sense to hold cash in reserve, because, at some point, they will have to write off some of these losses.
3.    Lack of Creditworthy Borrowers - Many creditworthy borrowers don’t desire credit, whereas many who desire credit aren’t creditworthy now that banks have raised credit standards. We’re back to that old lament about bankers, “Banks only want to lend you money when you don’t need it.”
4.    Collateral Values - Most assets have declined in value over the past three or four years, which means that bankers can no longer assume that the collateral for new loans will retain its value. In addition, falling asset values have changed the minds of many would-be borrowers. During the boom times, many investors fought to borrow every penny they could to buy assets, but now they are less aggressive.

All of these reasons for diminished lending combined with President Obama's proposed bank tax and the resurgence of Glass-Steagall (separation of banking from investing) add up to trouble for banks. One bank, in particular is having a difficult time. Citigroup is the fifth-largest U.S. bank by assets, and it seems to be the slowest buffalo in the herd of large banks, based on its performance since August. Its price chart displays a clear corrective rally from March-August 2009 with two equal up legs separated by a triangle. So long as Citi's price remains below 4.31, we can assume that our count is correct, and that Citi is headed lower in a third wave.
Citi’s problems exist despite a positively sloping yield curve which has often pointed to better times ahead. But, as we wrote in our inaugural Weekly Insight on June 12, 2009, “Even though a steep curve existed [in Jan 2002], the S&P 500 didn’t bottom until 10 months later in October 2002, and it had another 31% to decline. So, the steepness of the yield curve couldn’t prevent another leg of a bear market.” We believe that today’s yield curve shows another false positive, and once again, that it will not be able to prevent another wave of the bear market. 

Disclosure: Long C puts

Disclosure: Long C puts