Mortgage Daily

Published On: February 23, 2006
Yield Curve Not Poised for Change

FDIC analyzes inverted Treasury yields

February 23, 2006

By COCO SALAZAR

photo of Coco Salazar
Banking regulators say the inverted state of the Treasury markets doesn’t signal economic hard times ahead — though it may indicate mortgage banking profit margins will continue to be squeezed.

Historically, a flattening spread between short-term rates and long-term rates has tended to foretell both slower economic growth and increased pressure on bank earnings, according to the FYI: An Update on Emerging Issues in Banking report released Wednesday by the Federal Deposit Insurance Corp. Furthermore, short-term rates have generally exceeded their longer-term counterparts up to two years ahead of a recession.

Early Thursday, the 10-year Treasury note yielded 4.55%, lower than the 2-year Treasury 4.71% yield. The inversion in the yield curve follows nearly two years of flattening activity.

“Based on … historical context, the flattening in the yield curve since mid-2004 has been on the minds of many economists and banking analysts,” the FDIC said in the report. “Sometimes, however, the yield curve flattens or inverts for reasons that may not necessarily foreshadow slower economic growth.”

In analyzing the spread between the 10-year Treasury yield and the federal funds rate, the FDIC said the yield curve did not invert before the two recessions that occurred in the late 1950s and early 1960s, a period when long-term yields were as exceptionally low as they are today.

Other examples of inaccurate growth signals that passed without a recession ensuing in the next two years include the briefly inverted yield curve during 1966, when the Federal Reserve decreased money supply growth in response to spiked inflation that resulted from surging job growth and falling unemployment; the near-inversions in both 1987, when the stock market crashed (Black Monday), and 1995, when a soft economic patch followed a 3 percent increase in the fed funs rate over a 13-month period; and the inversion in 1998 that came during the financial market turmoil surrounding the collapse at Long-Term Capital Management, according to the report.

Since the 1990s, the relationship of short- and long-term yields moving in the same direction has been disappearing, the FDIC noted.

A suggested explanation for the flattened yield curve during the past two years is the reduction in the term premium. The FDIC said increased stability in global financial markets perhaps motivated increased investor demand for long-term securities, which has caused yields on these securities to fall.

Expectations of lower long-term inflation, an important component of the term premium, could also be behind the narrowing of the curve. Expectations of higher inflation push investors to require a higher inflation premium in the form of higher long-term interest rates to compensate for the value inflation may erode from their investment in the future, according to the report.

Other reasons that could be depressing long-term yields is the strong demand by foreign central banks for longer-term debt and the investment activities by pension funds and hedge funds, the FDIC said.

Because “past recessions only occurred with a high frequency after the curve inverted by a significant amount for a sustained period of time,” and the yield curve spread can invert for reasons other than the possibility of slower economic growth, the curve’s recent behavior “may not be signaling increased odds of a recession at present,” the insurer said.

“By the same token, the structural forces holding long-term interest rates down may be with us for some time, even as the cyclical increase in short-term rates subsides,” it added. “The presence of these structural forces suggests that a flat yield curve could persist for some time.”

For lenders, that scenario could translate into widespread narrowing of interest margins and lower earnings.

Since mid-2004, the median net interest margin for banks with total assets over $10 billion has fallen in tandem with the flattening yield curve, but it has increased for institutions with a size under $10 billion. This, because the median yield on assets for larger banks has consistently been about 50 basis points below that of smaller banks, but the relative cost of funding those assets at the largest banks has risen faster over the same period, the FDIC explained.

“While many banks have found ways of reducing their sensitivity to changes in yield curve spreads in recent years, the largest banks have seen their margins squeezed substantially,” the FDIC noted.

“Even so, it may be just a matter of time before margins for smaller banks begin to be squeezed, especially if the flat yield curve persists” for several more quarters, the FDIC said. But, regardless “of the slope of the existing yield curve — positive, flat, or negative — bankers will benefit from strategies designed to cope with the uncertainty of changing interest rates.”


Coco Salazar is an assistant editor and staff writer for MortgageDaily.com.e-mail: [email protected]

FREE CALCULATORS TO HELP YOU SUCCEED
Tools for Your Next Big Decision.

Amortization Calculator

Affordability Calculator

Mortgage Calculator

Refinance Calculator

FHA Mortgage Calculator

VA Mortgage Calculator

Real Estate Calculator

Tags

Pre-Approval Resources!

Making well educated decions in a matter of minutes and stay up to date on the latest news Mortgage Daily has to offer. Read our latest articles to stay up to date on what’s going on…

Resource Center

Since 1998, Mortgage Daily has helped millions of people such as yourself navigate the complicated hurdles of the mortgage industry. See our popular topics below, search our website. With over 300,000 articles, we are guaranteed to have something for you.

Your mortgages approval starts here.

Add 1-2 sentence here. Add 1-2 sentence here. Add 1-2 sentence here. Add 1-2 sentence here. Add 1-2 sentence here.

Stay Up To Date with Today’s Latest Rates

ï„‘

Mortgage

Today’s rates starting at

4.63%

5/1 ARM
$200,000 LOAN

ï„‘

Home Refinance

Today’s rates starting at

4.75%

30 YEAR FIXED
$200,000 LOAN

ï„‘

Home Equity

Today’s rates starting at

3.99%

3 YEAR
$200,000 LOAN

ï„‘

HELOC

Today’s rates starting at

2.24%

30 YEAR FIXED
$200,000 LOAN