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Yield Curve Inverts Again: What Does This Mean for Banks?

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Yield curve has inverted again, and that too the most since 2007. An inversion of yield curve means that short-term interest rates are higher than the long-term ones.

On Wednesday, the yield on the 10-year Treasury note dipped below the yield on the 3-month bill. Many see this as warning of an impending economic slowdown or even recession. Although the spread between the 2-and 10-year notes (which many investors consider as most important) remained positive, it has narrowed down considerably.

What Caused the Inversion?

The recent slide in bond yields seems to be in response to a number of factors, including economic woes, continued dovish stance of the Federal Reserve and geopolitical concerns. Investors are also concerned about fading positive impact of tax cuts on the U.S. economy.

Talking about the economic concerns, China is at the forefront. Muted economic data from China, mainly as a result of heightened trade tension, weighed on bond investors’ sentiments. With no near-term resolution to trade war in sight, this is expected to have a significant long-term global impact.

European economy is also showing signs of weaknesses. All these matters are projected to have some adverse impact on the U.S. economy too.

Banks & Yield Curve Inversion

Broader markets ended yesterday in red as these issues weighed on investor sentiments. Bank stocks did not remain untouched either. Major global banks – JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) , Wells Fargo (WFC - Free Report) and Citigroup (C - Free Report) – were down from prior day’s closing price.

Inversion of yield curve is bad news for banks. Banks earn net interest income (NII) by charging borrowers higher long-term interest rates while doling out smaller interest rates to depositors. This results in improvement in net interest margin (NIM).

As the yield curve inverts and the spreads between short-and long-term rates narrows down, growth in banks’ NII is expected to get hampered. This is also expected to lead to decline in NIM.

Further, inversion may put pressure on the Fed to cut interest rates, which has already put the rate hike on halt. Therefore, profitability of banks, which are one of the biggest beneficiaries of the interest rate increases, is anticipated to get hurt.

Additionally, as financial health of the nation has direct relation to the banks’ profitability, economic slowdown will result in pessimistic stance. While, at present, banks are performing well financially and also undertaking several restructuring and streamlining measures against the impending downturn, investors must be cautious and invest in fundamentally sound banks to earn solid returns.

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