As the gap between short-dated yields and their long-dated peers narrows, flattening the Treasury curve’s natural upward slope and threatening a so-called inversion, the upshot may be a lending market that seizes up and contributes to worries of an impending economic slowdown.
Mark Holman, a bond fund manager at TwentyFour Asset Management, says that a flat curve or a phenomenon known as a yield-curve inversion, where shorter-dated Treasury debt rates rises above longer-dated ones, would likely compel banks to restrict lending, slowing the economy’s momentum as corporations struggle to find financing, likely laying the groundwork for a recession.
In that way, Holman says, the widely used statistic that such inversions have been accurate predictors of every recession since 1975, could become a “self-fulling prophecy” because it would upend the engine of the economy: the banking sector.
The spread between the 2-year note
and the 10-year note
—the yield curve that Wall Street watches most closely for signs of inversion, currently trades at 12 basis points. On Monday, the 3-year note
yield rose above the 5-year note
marking the first time since 2007, but that pair is a less closely watched for signs of a recession.
See: This chart may be a key reason the stock market is plunging
Holman says the close relationship between banks and the yield curve’s movements came to the fore in the most recent edition of the Federal Reserve’s quarterly survey of senior loan officers. Banks said they would tighten lending standards if the yield curve were to invert as it would signal “a less favorable or more uncertain economic outlook and as likely being followed by a deterioration in the quality of their existing loan portfolio.”
Specifically, the central bank asked if the 3-month Treasury bill
remained at its current range, what would banks do when the 10-year note yield touched or fell below those levels. The 3-month bill is trading at 2.41%, according to Tradeweb data.
Holman, however, said for the benchmark bond yield to fall to 2.4%, “economic growth would have to deteriorate considerably,” said Holman. Under those circumstances, banks would likely pare back lending anyway.
Still, banks will be eyeing the yield curve’s movements closely, he said. A flatter curve is often seen as negative for banks lending margins’ because financial institutions make money on the differential between short-term rates they pay to clients and the yield from longer-term lending. As that gap narrows, banks are inclined to slow lending, cutting off a vital flow of funds to the economy.
Bank stocks and their proxies have been hard-hit by the flattening curve. The Financial Select Sector SPDR Fund
is down 5% this week, while the Invesco KBW Bank exchange-traded fund
is down by more than 6% over the same period.
Read: Banks would tighten lending standards if yield curve inverts, new Fed survey finds
Although banks aren’t the only game in town, other nonbank lenders and corporate bond markets have already started to become more restrictive, signaling a tightening in that segment of the capital markets. The average yield for a basket of U.S. investment-grade corporate bonds has climbed more than 1.1 percentage point to 4.37% Tuesday since the year’s start, according to the ICE BofAML debt index. That’s the highest since 2010. Bond prices move in the opposite direction of yields.
The Securities Industries and Financial Markets Associated reported that corporate debt issuance was down 17.2% year-to-date from the same period in 2017.
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