An inverted yield curve is a reliable predictor of recessions but it also warns of falling bank profits. When the spread between long-term Treasury yields and short-term rates is below zero, net interest margins are squeezed.
In a normal market, with a steep yield curve, net interest margins are wide as bank’s funding maturity is a lot shorter than their loan book. In other words, they borrow short and lend long. Few bank deposits have maturities longer than 3 to 6 months, while loans and leases have much longer maturities and command higher interest rates.
When the yield curve inverts, however, the spread between long and short-term rates disappears and interest margins are squeezed. Not only is that bad for banks, it’s bad for the entire economy.
When their interest margins are squeezed, banks become risk averse and lending growth slows. That is understandable. When interest margins are barely covering operating expenses, banks cannot afford credit write-downs and become highly selective in their lending.
Slowing credit growth has a domino-effect on business investment and consumer spending on durables (mainly housing and automobiles). If there is a sharp fall in credit growth, a recession is normally not far behind1.
Right now, the Fed is under pressure to cut interest rates to support the US economy. While this would lower short-term rates and and may flatten the yield curve, cutting interest rates off a low base opens a whole new world of pain.
Quartz this week published a revealing commentary on the damage that negative interest rates in developed economies are doing to bank net interest margins :
The problem for commercial banks is that government bond and mortgage interest rates keep going lower, but it isn’t as easy to cut deposit rates — the rate at which banks themselves borrow from customers — at the same pace. After all, it’s tough to convince people to keep deposits in an account that returns less than they put in (even though this already happens, invisibly, through inflation).
Ultra-low interest rates are likely to squeeze bank margins in a similar way to the inverted yield curve. And with a similar impact on credit growth and the economy.
If I was Trump I would be pleading with the Fed not to cut interest rates.
Footnote:
1. The NBER declared a recession in 1966 when the S&P 500 fell 22% but later changed their mind and airbrushed it out of history.