Why the flattening yield curve is bad, and what it means for banks

Melpomenem/iStock via Getty Images

The U.S. Treasury yield curve is flattening to levels not seen since the deflationary shock at the onset of the COVID-19 pandemic, implying that the bond market (NASDAQ:TLT) (NASDAQ:SHY) (NASDAQ:IEF) (NYSEARCA:ZROZ) sees weaker economic growth and possibly recession risks if history serves as any guide. This comes as the Federal Reserve is expected to hike the policy rate to above neutral to tame inflationary pressures.

Yield curve 101: The Treasury yield curve is the spread between two different interest rates tenors, say the difference between the 10-year UST yield and the 2-year. When the curve's slope is inverting (downward sloping), short-term bonds yield more than long-term ones, meaning investors are more optimistic for the months ahead than they are for the years ahead.

Will flattening/inverting curve hurt banks' profitability?

In practice, a flattening or inverting yield curve tends to hinder banks' net interest margins since they can only borrow money at higher rates and lend at lower rates. Bank stocks (KBE) have been underperforming the stock market (SP500) since the yield curve first started its cyclical decline in mid-March 2021, looking at the chart here. "If the risk of a US recession on the back of an inverted yield curve becomes the overarching concern…this is likely to challenge bank stock outperformance," Bank of America analyst Ebrahim Poonawala wrote in a note to clients Wednesday.

Some history: During the 2004-2006 Fed rate hike cycle, in a backdrop of concerns over a housing bubble, the 2s10s yield curve inverted towards the end of the cycle in June 2006, Poonawala said. During that time frame, bank stocks rose in-line with the S&P 500. But many regulations, such as the Dodd-Frank Act, were passed post-GFC to mitigate systemic risks like excessive leverage and loose underwriting standards. Banks have since been subject to strict leverage/reserve ratios that would protect them from those risks.

While bond investors expect the Fed's new tightening cycle to slow economic growth in the wake of surging inflation, bank stocks could gain some upside if the Russia-Ukraine crisis shows "any signs of de-escalation," Poonawala said. BofA's top ideas with factors including domestic, spread dependent and rate sensitive, include Wells Fargo (WFC), M&T Bank (MTB), East West (EWBC), Signature (SBNY), Silvergate Capital (SI), SVB Financial (SIVB) and KeyCorp (KEY).

The 5s10s yield curve is already inverted (below zero), recently standing at negative two basis points, the lowest level seen since the curve was inverting prior to the Great Financial Crisis of 2007/2008, as seen in the chart below. The 5s30s slope is narrowing to the lowest since 2007 as well. 2s10s curve is also trending in a downward spiral, suppressed by negative term premia (meaning bond investors expect to pay for protection against losses), recently changing hands at just 21 basis points.

Meanwhile, BofA analyst Aditya Bhave doesn't seem concerned about a near-term recession, in fact, those concerns are "likely overdone," as the economy and labor market have robust momentum and should benefit from reopening tailwinds through 2022. However, recession risks "will probably be much higher" in the second half of 2023, according to a note written to clients. Recall during the most recent Federal Open Market Committee meeting - when the policy rate was lifted off the effective zero lower bound - that 12 out of 18 Fed officials predicted at least seven total rate hikes in 2022.

Fed behind the curve?

“The Fed admittedly is way behind the curve. Inflation is extraordinarily high,” Chief investment Strategist Liz Ann Sonders told Politico. “But in the current environment, if we can keep growth hanging in there, the labor market strong, productivity strong, maybe the bet is, OK, we can handle tighter monetary policy.” Some Fed officials have urged the FOMC to remain cautious on the speed of rate hikes.

See why J.P. Morgan's Kolanovic is skeptical of the inverting yield curve.

Take a look at SA's Guide to Economic Recessions.