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Falling bond yields can be bad for bank stocks, especially if a recession is brewing. How should investors navigate through the current warnings coming from the bond market?

Canadian and U.S. bank stocks are down from recent highs earlier this year, reflecting trade tensions, economic uncertainty and a remarkable decline in government bond yields.

Some US$15-trillion in government bonds have negative yields (yielding less than 0 per cent), raising concerns that this is an emerging global trend. And while U.S. Treasury bond yields have rebounded over the past several days, they continue to weigh on the economic outlook as markets bet that the U.S. Federal Reserve will cut interest rates.

The stakes are particularly high for bank stocks, which are economically sensitive and can see their lending margins crushed when rates fall.

“Today, we believe that all of us – bank stock investors, bank management teams, regulators, the Federal Reserve, etc. – are entering uncharted waters that are likely to be full of surprises and risks but also rewards for those who are steadfast in their thinking and nimble on their feet,” Gerard Cassidy, a U.S. bank stock analyst at RBC Dominion Securities, said in a note.

The risks are clear: Investors and U.S. bank management teams have never operated in an environment of negative interest rates, which would hamper bank lending activity. While the focus of Mr. Cassidy’s note is on U.S. banks, Canada’s big banks operate in a similar environment and many of them now have significant U.S. exposure.

“If bank stock investors’ base case scenario is for nominal [before inflation] rates across the yield curve to move to negative interest rates similar to Japan, bank stocks should be sold,” Mr. Cassidy warned.

He added: “While the problems that preceded the emergence of Japan’s Zombie Banks in the 1990s are not exactly analogous to U.S. banks today, the difficulty of operating through a generation of extremely low interest rates remains a sobering reminder for U.S. bank stock investors.”

Despite this sober warning, Mr. Cassidy isn’t bearish on U.S. bank stocks. He argues that the potential rewards outshine the risks, which is potentially good news for Canadian bank stocks, too.

On Monday, the SPDR S&P Bank ETF, which reflects the U.S. banking sector, rose 3.3 per cent. Canada’s Big Six banks rose by an average of 0.7 per cent – suggesting that the stocks move in the same direction when bond yields rebound. The yield on the 10-year U.S. Treasury bond rose to 1.63 per cent, up eight basis points (there are 100 basis points in a percentage point).

But what if bond yields slump again in anticipation of central-bank rate cuts?

Mr. Cassidy has a few thoughts here. First, he argues that credit quality is more important than interest rates.

“Today, credit quality remains strong and is expected to remain benign for the next 12-18 months. Furthermore, we envision that the next credit cycle will be more similar to the 2000-01 credit cycle than the 1990-91 or 2008-09 credit cycles due to the de-risking of most bank balance sheets, stronger capital levels, and management memories of the horrific 2008-09 period.”

Although he expects that the next credit cycle will lead to a sell-off in bank stocks, prices should rebound quickly when investors realize that the downturn won’t deliver dividend cuts or a depreciation of book values.

Second, Mr. Cassidy argues that forecasting interest rates is difficult to get right, and relying on fund futures or Federal Reserve officials doesn’t help. Last year, for example, fund futures were predicting continuing rate hikes by the Fed, which instead cut its key rate in July.

“Bank stock investors certainly should analyze trends in interest rates and the shape of the yield curve, but we all should be very cautious about assigning too much weight to interest rate forecasts in making investment decisions,” Mr. Cassidy said.

And third, he pointed out that while bank net-interest margins (what the banks make on loans) tend to fall when interest rates decline, bank stocks have performed well during previous rate-cutting cycles when the economy expands.

“As a result, we anticipate that bank stocks should do well over the next 12-18 months as long as we do not enter a recession or the U.S. Treasury curve goes completely negative,” Mr. Cassidy said.