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Bank investors, meet your new best friend: a steeper yield curve.

Canada’s Big Six bank stocks have risen nearly 15 per cent since the start of November, on average, and are now down less than 4 per cent for the year. The gain this month has outpaced both the S&P/TSX Composite Index and the S&P 500 over the same period, after bank stocks lagged the benchmarks throughout most of 2020.

To be sure, there are several factors working in the banks’ favour right now.

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The results of the U.S. presidential election have fuelled hopes for economic stimulus. Upbeat news on vaccine tests over the past few weeks, first from Pfizer Inc. and then from Moderna Inc., have ignited hopes for a stronger economic recovery in 2021.

And some observers expect that Canadian banks are over the worst of the credit cycle after setting aside billions of dollars earlier this year to cover bad loans.

But the role of the yield curve, which compares short-term government bond yields with longer-term government bond yields, is a welcome tailwind that could help lift bank stocks even as vaccine euphoria wears off – that is, if the yield curve plays along.

The yield curve directly affects the banks’ “spread” – or the difference between the interest rate they charge borrowers and the rate they pay depositors. The curve was flat for most of the year, and it briefly inverted in 2019, as low long-term bond yields reflected a grim economic outlook. As a result, bank margins on loans were compressed, adding another constraint to bank profits.

This may be changing now, if fitfully. The yield on the 10-year U.S. Treasury bond peaked as high as 0.96 per cent on Nov. 10, up 45 basis points from a recent low in August (there are 100 basis points in a percentage point). The Government of Canada 10-year bond followed a similar path.

That’s the long end of the yield curve. Now consider the short end: Canadian and U.S. central banks have essentially promised to leave their key interest rates at ultralow levels, potentially for years. In June, Federal Reserve chair Jerome Powell said that the Fed is “not even thinking about thinking about raising rates.”

These telegraphed views are exerting downward pressure on short-term bond yields, sending the U.S. yield curve earlier this month to its steepest level in nearly three years – and adding to the appeal of bank stocks.

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The problem? The steeper yield curve is not staying put: Longer-term bond yields retreated over the past week amid soaring COVID-19 infections, and the yield curve for Canadian government bonds remains relatively flat.

“The key takeaway message is that even amid the fireworks in equities and some other markets on the vaccine news, bonds are weighing that evenly against the clear near-term negative news,” Doug Porter, chief economist at BMO Nesbitt Burns, said in a note.

Some observers expect that the longer term is not much better. Oliver Jones, a senior markets economist at Capital Economics, argued recently that low inflation and bond purchases by central banks will keep the yield curve relatively flat for some time.

But investors may be sensing that any steepening in the yield curve is good enough.

By one rough measure of sensitivity to the yield curve, Royal Bank of Canada expects its profits will rise by $479-million for every 100-basis-point increase in the yield curve.

That’s not a bad tailwind. And it comes at a time when valuations remain relatively low. Bank stocks trade at just 10.5 times estimated 2021 profit, according to RBC Dominion Securities, lower than the 15-year average price-to-earnings ratio of 11.1.

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Valuations could rise as investors gain more confidence in the sector. A return to dividend increases, on hold since the pandemic struck financial markets earlier this year, would no doubt boost confidence. Some analysts believe dividend hikes will return next year as lending picks up.

“Fiscal stimulus, monetary stimulus, strong house prices and a vaccine should encourage consumer spending and business investment,” Paul Holden, an analyst at CIBC World Markets, said in a note.

A steeper yield curve would no doubt underscore the economic optimism that underpins so much of what banks do. It helps explain the recent rally in bank stocks – and will be needed to keep the rally going.

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