Flattening US yield curve: a gloomy sign for banks?

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An important measure of the US yield curve has given up its post-election surge and then some, in what could be a bearish indication for lenders.

The difference in yield between 10-year and three-month Treasuries has dropped to 1.38 percentage points, from 1.56 pp at the start of April and as high as 2.09 pp in December. That places the spread at its lowest level since October 5, according to Bloomberg data.

Flattening of the curve suggests “the outlook for [economic] growth has weakened” but that the dimmer expectations have not yet been priced into forecasts for Federal Reserve rate rises, said Dennis DeBusschere, head of portfolio strategy at Evercore ISI.

Sean Darby, chief global equity strategist at Jefferies, notes that “it remains to be seen whether the bear flattening of the US yield curve is due to concerns over lower US growth/inflation or a reflection on the lower probability of the new administration succeeding with its original mandates”.

“Not only has there been back-tracking on foreign relations, but there has also been a roller-coaster ride on financial deregulation, protectionism and the possibility that President Trump might hand a second term to [Janet] Yellen as chairwoman of the Fed,” he added.

The steepness of the yield curve is of particular importance to lenders, since they make profits by borrowing in the short term — through deposits, for instance — and lending over longer time periods. Indeed, the steepening in the curve following the election of Donald Trump helped to send the KBW banks index — which tracks the shares of America’s biggest lenders — 32.2 per cent higher from November 8 – March 1. However, it has since dropped 10.7 per cent.

More selling could be on the way for banks, notes Peter Cecchini, chief market strategist at Cantor Fitzgerald: “We feel that large cap bank stocks are pricing in a much steeper yield curve and swift regulatory reform”.

Bank of America presents a case study of this concern. The second-biggest US lender by assets — which is considered to be especially sensitive to rates because of its large retail business — said on Tuesday that its net interest income rose $766m from the fourth quarter of 2016 to $11.1bn in the first quarter of 2017.

However, chief financial officer Paul Donofrio cautioned in a conference call with analysts that while net interest income should continue to increase, “the improvement is expected to be much more modest” in the second quarter, given that the rise in long-term rates drove a “significant portion” of the increase in the first three months of this year.

BofA’s guidance “raises concerns about the long-end of the curve, ” said Brian Kleinhanzl, analyst at Keefe, Bruyette & Woods. He notes that KBW currently expects the 10-year Treasury yield to close the year at 2.9 per cent, from its current level of below 2.2 per cent, “so if the long-end of the curve does not pick up then our, and the Street’s, [net interest income] forecast may prove to be too optimistic”.

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