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Explainer – Why an inverted yield curve might not be all bad for US banks

FILE PHOTO: US one dollar bills are seen in front of the displayed stock chart in this image
FILE PHOTO: U.S. one-dollar bills are seen in front of the displayed stock chart in this February 8, 2021 illustration. REUTERS/Dado Ruvic/Illustration

March 30, 2022

By David Henry and Michelle Price

(Reuters) – The US Treasury yield curve, widely regarded as a barometer of the health of the economy, was briefly ‘inverted’ on Tuesday to give a warning sign to bond investors anticipating a recession on the horizon.

While investors warn that the yield curve is just one indicator among many to look for when predicting a recession, its changing shape can make it difficult for banks to see margins between their funding costs and the interest they charge on loans and securities earn, manage what is also known as a “recession” their net interest income. Here’s what the yield curve inversion could mean for US lenders.

WHAT JUST HAPPENED?

2-year government bond yields rose higher than 10-year government bond yields for the first time since 2019.

That’s unusual because investors typically expect higher compensation for the risk that rising inflation will lower the expected returns from owning longer-dated bonds. That means a 10-year bond will typically yield more than a 2-year bond.

An inverted curve has historically preceded recessions and can serve as a warning sign of such an event. The US Federal Reserve has started raising interest rates and is expected to continue to do so aggressively into 2022.

IS THIS BAD FOR BANKS?

Type of. Banks generally borrow short and lend long and make money on the different interest rates when the curve is tilted.

A reversal of 2-year and 10-year Treasury yields means there is no spread to be earned between borrowing for two years and collecting interest on 10-year Treasuries.

IN REALITY IT IS NOT THAT BAD

In practice, however, banks borrow and lend at different points on the curve and tend to limit the average maturities of loans and securities to less than about five years.

They rarely borrow much for two years and lend for 10 years. They tend to borrow and lend more at the front, or short-term, end of the yield curve, which is steep. For example, the spread between 3-month and 5-year bonds as shown on the Treasury curve was about 190 basis points on Tuesday.

For example, JPMorgan Chase & Co funds more than half of its balance sheet with low-cost deposits, the cost of which tends to increase very slowly. The average interest rate on all of JPMorgan’s interest-bearing debt was just 0.22% in the fourth quarter. That’s a far cry from Tuesday’s 2.4% yield for 2-year Treasuries.

Also, many commercial and industrial loans are adjustable-rate loans or variable-rate revolving credit facilities tied to short-term benchmarks, which have risen sharply this year in anticipation of Fed rate hikes.

Banks have predicted that rate hikes will boost their net interest income significantly this year.

The bigger threat to banks is the risk of a recession, which could hurt consumer spending and hamper Americans’ ability to pay back loans.

(Reporting by David Henry in New York and Michelle Price in Washington; Editing by Megan Davies and Matthew Lewis)

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DUSTIN JONES

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