When the U.S. yield curve inverts bad things tend to happen.
It’s a lesson many investors seem reluctant to learn as there’s always a tendency to assume it’s different this time.
But whether it’s stress in the banks, financial markets or the wider economy, an inversion of long-term bond yields below short-term funding rates is almost always a signal that a credit-driven economy faces trouble ahead. And that’s mainly because it causes the problem.
The volatility crashing through the U.S. banking sector, which triggered late night intervention from U.S. regulators on Sunday to curb a contagious flight of deposits from smaller, weaker banks to larger ones, is just the latest example.
The implosion of Silicon Valley Bank (SVB) - America’s 16th largest bank - prompted the Treasury and Federal Deposit Insurance Corp (FDIC) on Sunday to say that all customers will be able to access their funds, while the Fed unveiled a new program offering institutions cheap and easy access to loans.
These steps were taken after SVB was shut down, forced to realize losses on its holdings of longer-dated Treasuries at the same time its deposit base was under threat. The aim was to ward off contagion spreading through the $23 trillion banking sector.
Ultimately, though, liquidity does not guarantee profitability. If longer-term profitability is authorities’ goal, they may have to engineer a lasting re-steepening of the yield curve back into positive territory
Deutsche Bank’s Jim Reid says inverted curves are almost always an ominous sign - they signal an eventual unwind of carry trades somewhere in the financial system or economy, meaning investors and economic agents are about to draw in their horns.
“I don’t care why the curve inverts, I just care that it does,” he said on Monday.
CARRY THAT WEIGHT
While SVB’s failure may not be a direct casualty of the inverted yield curve, an inverted curve is a sign that wider financial conditions are not so easy, presenting banks with a far more challenging economic and financial environment.
There are several measurements of the gap between short- and longer-dated yields but the ‘2-year/10-year’ is the benchmark - it goes back decades, captures highly liquid parts of both ends of the curve, and its inversion has preceded every recession of the past 45 years.
The two-year Treasury yield has been higher than the 10-year yield since last July as the Fed has embarked on its most aggressive rate-raising campaign in decades. The gap reached 110 basis points (bps) last week, the deepest inversion since 1981.
In that light, Treasury Secretary Janet Yellen, Federal Reserve Chair Jerome Powell and FDIC Chairman Martin Gruenberg may have welcomed the 2s/10s curve steepening by 40 bps on Monday, the most in decades - only another 50 bps to go and the curve will be sloping up for the first time since last summer.
Banks make money when the yield curve slopes positively, borrowing cheaply via customer deposits, central bank windows or the short end of the curve, and lending longer term at higher rates - a classic ‘carry trade’.
A downward-sloping curve stymies this ‘carry’ and curbs lending, and the consequences are clear when that lasts for as long as eight months.
Analysts at JP Morgan say regulators’ actions successfully targeted a specific carry trade in a specific area, but there are many others and not all can be backstopped.
Private equity, venture capital, auto loans, levered loans, and credit card lending have all been profitable in the era of cheap short-term funding. But rising financing costs put the squeeze on them and hasten the end of the cycle.
“We believe we are in that stage and remain negative on risky asset classes,” the JP Morgan analysts wrote in a note on Monday.
REASONS TO BE FEARFUL?
When banks’ cost of funding exceeds the rate of return, they will naturally be less inclined to lend. Tighter credit conditions and lending standards mean consumers borrow and spend less, and firms hire and invest less and the risk of recession increases.
There are good reasons for caution right now.
Outstanding credit card debt has hit its highest on record at almost $1 trillion, in nominal terms, and average credit card rates have already hit a record high above 20%.
Average 30-year mortgage rates are back above 7%, having doubled in the last 18 months, while the personal savings rate remains anchored near multi-year lows below 5%.
The Fed’s last Senior Loan Officer Survey shows that the net percentage of banks reporting tightening standards for commercial and industrial loans in the fourth quarter of last year jumped above 40%, levels consistent with past recessions.
“When you have record inversions for a prolonged period of time it does point to slower financial intermediation, slower credit and loan provisions,” said Gregory Daco, chief economist at EY.
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