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The FED can no longer ignore the inverted yield curve

The recent collapse of Silicon Valley Bank means the Fed can no longer ignore the inverted US yield curve in its interest rate decisions. Not because it foretells a recession as was initially feared by some investors, but because it may be the new source of stress for US banks. Negatively inverted curves are detrimental to banks’ health because banks generally pay short term rates to depositors and receive long term rates from their borrowers. The current economic landscape poses a dilemma for US banks, especially those with low pricing power. This is because net interest margin, a key measure of banks’ profitability, being compromised big time.

Graph 1: 10-year Treasury Constant Maturity Minus 3-MonthTreasury Constant Maturity

Source: Bloomberg

Graph 2: US Yield curve

Source: Bloomberg

What is a yield curve?

A yield curve reflects yield differences among bonds of the same credit quality as maturity dates extend. Usually, the bond with a long-term maturity should compensate the holder with a higher yield compared to a holder of a short-term bond, because of the uncertainty associated with this.

The yield curve assists in determining investors’ expectations of interest rates over the long-term period and the uncertainty associated with this. Graph 1 shows the difference between the yields on a 10-year and 3-month same credit quality bonds over time. What we can see currently from last quarter of 2022 is that the 3-month yields are above 10-year yields of the same quality bond. What this means is that the yield curve is inverse, which can also be seen on graph 2 which shows the yield curve as of 16th January 2023. An inverse yield curve is an unusual but possible phenomenon and has been used before as a leading recession indicator.

What may happen?

Currently, the Fed is raising interest rates to combat inflation. However, the Fed will have to trade more carefully in light of the greater risk of bank failures.  Largely because of this, a 50bp hike at the FOMC next week is out of the question.  

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