The Yield Curve Flattens

OK I can hear you all saying: ‘What?’. Here’s the report from MarketWatch:

Yield curve flattens in wake of Fed moves, no help for banks – MarketWatch

I only offer this arcane news to you as part of my ongoing attempt to simplify things. The yield curve is an expression of the relationship between interest rates on Government notes and bonds of different maturities. So it literally is a line drawn on a page with the rates for the short term notes like three month Treasury Bills on one side and those for longer maturity notes like thirty years bonds on the other.

Under normal circumstances the rates on shorter maturities should be lower than those for longer maturities, so the line would curve up from left to right on the page. Hence ‘Yield Curve’.

When the economy hits rough waters though the yield curve alters its shape and can sometimes even ‘invert’ with shorter term notes having higher rates than longer term notes. Such an inversion often portends a recession, because it shows that the combination of Fed actions and money market expectations have driven rates up for notes maturing in the near future, but that the market expects that rough patch to go away and so is willing to accept lower rates further into the future.

Another important piece of information we can derive from the yield curve is the pressure on bank profits: banks typically borrow short, at the low end of the curve, and lend long at the higher end. they make a margin on being able to do this. This playing the curve for profit is called ‘intermediation’ and is a major contributor to normal bank income. So a flatter yield curve indicates a more difficult income environment for banks and less opportunity for profit.

As the article points out: this flatter curve is only one of the banking industry’s difficulties right now. Rotten asset portfolios, write-offs, and insufficient capital are stealing the headlines currently. There are probably plenty of bankers who wish the flat curve was their only problem.

In any case this is another sign that the financial system is a long way from healthy.

The road to recovery is going to be both long and ugly.