Normalizing Yield Curve Triggers Economic Concerns

In the summer and fall of 2022, two measures of the yield curve inverted: the 10-year minus 2-year U.S. Treasury yield curve, and the 10-year minus 3-month yield curve. As seen in the chart below, an inverted yield curve has historically been a leading indicator of a recession (gray bars). In this most recent cycle, however, the economy has continued expanding.(1)

Yield Curve Inversions Have Historically Preceded Recessions

Fast forward to the present day, and the 10-year minus 2-year Treasury yield curve (red line in the chart above) is back to normal, which has set off a fresh wave of economic concerns. Some pundits have pointed out that recessions occur shortly after a yield curve ‘un-inverts,’ which would imply that trouble is near. The Federal Reserve also has a long history of being too late in easing monetary policy, potentially deeming this week’s policy pivot as yet another example of this shortcoming.

I see a key issue with these arguments, however. The inverted yield curve has been a reliable recession indicator in the past, but it’s because of the effect it has had on bank lending and credit availability across the broad economy. When bank profitability gets squeezed by high short-term (deposit) rates and relatively low long-term (lending) rates—which is what an inverted yield curve does—banks tend to issue fewer loans. Net interest margins are too low.

This drop-off in lending results in a credit contraction across the economy, which weakens investments and precludes downturns.?

In 2023 and year-to-date 2024, however, the inverted yield curve did not produce these outcomes at the extreme. When long-term interest rates went up, banks experienced a substantial jump in net interest income they were generating (chart below), even though the yield curve inverted during this period. Banks were able to maintain this nicely positive spread because they simply didn’t raise deposit rates by very much. They didn’t have to. To this day, many banks pay deposit rates far closer to 0% than the current ~5% rate on 3-month U.S. Treasury bonds.

Banks have been able to keep deposit rates low because in the wake of the pandemic, they were flooded with new deposits as trillions of dollars of federal stimulus were transferred to American households. As short-term interest rates rose, banks had little need to compete for new deposits, and therefore many were not compelled to raise deposit rates. Net interest margins were preserved, and banks remained profitable.

The inverted yield curve was not meaningless during this period, however. Combined with 2023’s regional bank crisis, we did see a significant impact on overall loan activity over the past year or so. As seen below, there was indeed a sharp decline in loans issued, which appears to have stabilized and remains positive as we presumably enter a period of falling short rates.?

Bottom Line for Investors

The implication here is not that the yield curve has lost its ability to predict economic strength or weakness. Investors just need to remember why the yield curve matters in the first place—because of its effect on bank profitability and credit availability across the economy. If banks were forced to raise deposit rates in a competitive environment for deposits, squeezing net interest margins in the process, then we may have experienced a major credit contraction event. But for the reasons explained above, that didn’t happen.

As the Federal Reserve pivots to monetary easing, the central question is whether they’ll be able to successfully engineer a soft landing. My message to investors is: if the U.S. economy was able to withstand a period of aggressive rate increases, with banks remaining profitable, then isn’t it possible that the economy and banks can absorb a period of falling rates too?

1 Wall Street Journal. September 11, 2024. https://www.wsj.com/economy/central-banking/a-recession-signal-is-flashing-red-or-is-it-da02b509?mod=economy_trendingnow_article_pos3

2 Fred Economic Data. September 7, 2024. https://fred.stlouisfed.org/series/T10Y3M#

3 Fred Economic Data. September 13, 2024. https://fred.stlouisfed.org/series/TOTLL#

4 Fred Economic Data. September 13, 2024. https://fred.stlouisfed.org/series/TOTLL#

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