Why the flattening yield curve could be a big blow for the banks

“Whether the yield curve is forecasting an economic slowdown or recession (accurately or not) or whether it is simply anticipating a fresh round of interest rate cuts and Quantitative Easing from nervous central banks remains open to debate. But one thing does seem certain and that is banking stocks do not like what they are seeing from the yield curve,” says Russ Mould, AJ Bell Investment Director. “Banking shares are doing badly not just in the UK but the US and Europe as well – and if there’s one sector that investors would like to know is in good health after their experiences of 2007-09 it is the banks, so this is a trend that needs to be watched.

Source: Refinitiv data. Capital return only. To 25 March 2019

“The yield curve measures the difference between different maturities of Government debt, with the gap between 2-year and 10-year paper a common benchmark.

“In theory, the yield on the 10-year should always be higher. This is simply because more things can go wrong in the life of a 10-year bond than in a 2-year one and investors will demand a higher yield as compensation for the higher risks, which, for fixed-income investors, come in the form of default, interest rate movements and inflation.

“But sometimes the gap between the 10-year and 2-year Government bond yields can narrow. This is often (though not always) because the yield on the 10-year falls quickly as markets price in an economic slowdown or recession and then central banks’ usual response, which is to cut interest rates in an attempt to boost the economy.

“At the moment, the yield on 10-year Government Gilts in the UK, Treasuries in the USA and Bunds in Germany is falling faster than the 2-year yield, to flatten the yield curve.

“As a result, banking shares are starting to struggle on the UK, American and European stock markets.

“The thinking behind this is that a flattening yield curve damages banks’ earnings power. 

“Banks tend to raise funds by borrowing in the short-term and lending over the long-term, in what it known as maturity transformation. The idea is that this enables them to borrow at a lower interest rate and lend money out a higher one, pocketing the difference as their profit – this is their so-called net interest margin.

“The problem now is that a flattening yield curve will be weighing on net interest margins. That will leave the banks relying on fees from any wealth management or private banking operations that they might have, or trading commissions and advisory fees from an investment bank, if they are brave and well capitalised enough to own one.

“We can already see how the net interest margin at the UK’s Big Five banks have started to come under pressure, or least stop expanding, and one key test of April’s first-quarter results will be the trend here. Downgrades to net interest margin expectations could well feed into cuts to earnings estimates and no matter how cheap a stock may look on book value, dividend yield or earnings it is generally pretty hard for it to perform, at least in the short-term, if profit forecast momentum is negative.”

Source: Company accounts