Unravelling the Conundrum of Inverted Yield Curves

One of the first questions when investing should always be, “why”? Because in understanding the “why”, we can have a better understanding of the “how”, which in turn gives the ability to maximise the returns from the question, “when”?

Within the intricate tapestry of investing, nowhere is this phenomenon more important, than the understanding of the why, in an inverted yield curve . An inverted yield curve, stands as a harbinger of intricate and far-reaching implications for banking institutions and the broader economic landscape. This article delves beyond the surface to explore the multidimensional repercussions of inverted yield curves, unravelling their profound impact on the intricate dance between banks' lending activities and the pulse of the real economy. To illuminate these complexities, we are going to delve into recent banking earnings reports pulsating with insights, juxtaposed against the backdrop of key economic indicators that serve as guiding stars in navigating the complex terrain of modern finance.

Unpacking the Impact of Inverted Yield Curves on Banks

To assess the impact of an inverted yield curve on banks and its broader implications for the financial system and the real economy, we can develop a time-series analysis of the yield curve itself,? against both the Federal Reserve fund and contraction in the economy. This approach can shed light on how an inverted yield curve serves as a market signal to the Federal Reserve, reflecting changes in liquidity and risk appetite within the financial system and serving as a leading indicator for the strength of the real economy.

Data Analysis

The chart above by Michael Lebowitz , really supports the argument that inverted yield curves pose challenges for banks by disrupting their traditional borrowing and lending practices. Each of the last six recessions have preceded an inversion in the yield curve. I want to examine historical data and examples from the dot-com bubble and the Global Financial Crisis (GFC) , to try and understand what the yield curve was telling us and how we can create a picture of what the inverted yield curve is telling us today.

Bubble in the late 1990s and early 2000s?

As we can see from the chart above, before the bubble burst the yield curve flattened as short-term rates rose faster than long-term rates, signaling an impending inversion. We also need to understand that the yield curve inverted, well before the collapse in equity prices. The inverted yield curve was the markets, understanding the risk, and reducing their own risk exposure. This is because short-term Treasury bills are the most liquid monetary asset, where long-term government debt in a falling interest rate environment could result in huge losses for investors, if they need to sell to cover margins.?

The result being, commercial banks faced narrowing net interest (NNI) margins as short-term borrowing costs increased while long-term lending rates remained relatively low. The tightening yield curve squeezed banks' profitability, resulting in the banks reducing their own risk and exposure, resulting in cautious lending practices amid concerns about potential economic risks and asset bubbles. So what in effect what happened, the bond market diversified and protected their assets, from what clearly was an asset bubble, within the tech sector. Are we seeing the same with AI stocks, like Nvidia ?

Global Financial Crisis (2007-2009)

The more you analyse the Federal Reserve fund rate before the GFC, the more you realise the incompetence of Federal Reserve policy before, during and after the GFC. The Federal Reserve, having rates around 1.5%, between 2003 and 2005, fueled the bubble, by reducing the cost of financing. However when they clearly released the policy mistake, they aggressively increased rates to 5.25%. This had the effect of compounding the pressure that had been created by the Federal Reserve, as subprime lending collapsed and with it interbank lending.?

This is because, the market having a greater understanding of market dynamics, understood, it was too late and the writing was on the wall for the economy as the subprime mortgage crisis imploded. As such, what the economy needed was lower Federal Reserve fund rates, as indicated by the inverted, yet the Federal Reserve pushed rates higher.

The yield curve inverted before the GFC, reflecting market distress and expectations of economic downturn, as by 2005 and especially 2006, defaults had already started to increase, while supply was out stripping demand. Banks facing challenges in maintaining profitable lending operations, as highlighted by the inverted yield curve, due compressed net interest margins. However, rather than contracting mortgages lending, banks leveraged up and doubled down, by allowing 100% LTV mortgages.?

By the time the full extent of the damage was realised, the interbank lending market had completely frozen, as banks curtailed lending activities due to liquidity constraints, credit market disruptions, and heightened risk aversion, exacerbating the impact of the on the financial system. By the time the Federal Reserve started to reduce rates in 2007, the financial system was so dysfunctional, the level of the Federal Reserve fund rate was irrelevant. This question investors need to ask, does the current CRE crisis, smile earlier similar to the subprime mortgage crisis??

Wells Fargo and JP Morgan Q1 reports

The earnings reports by Wells Fargo and JP Morgan , highlighting the fall in net interest income (NII), is a clear sign of a regression, in profitability and lending, due to the spread between short-term and long-term interest rates. This divergence in profitability by industry giants such as Wells Fargo and JP Morgan, has the market really spoked, especially in relation to regional banks, given their exposure to CRE . This analysis can provide insights into the challenges faced by banks and the implications for lending to the real economy.

JPMorgan, the largest U.S. lender, said in February that its market revenue could decline 5% to 10% in the first quarter. Analysts are weighing how the path of U.S. interest rates will bolster banks' NII, or the difference between what lenders earn on loans and pay out for deposits. "This is the overarching theme this quarter and we are likely to see an upside for earnings," said Kenneth Leon, research director at CFRA Research. Source: (Reuters )

The statement in their report from JPMorgan, indicating that its market revenue could decline in the first quarter, and Q1 analysis, highlights the potential impact of changes in the yield curve structure on banks' profitability, particularly concerning the NII margin. When the yield curve flattens or inverts, with short-term interest rates exceeding long-term rates, it can squeeze banks' NII margins. This is because banks typically borrow at short-term rates and lend at long-term rates, generating income from the interest rate spread. This flattening yield curve may reduce this interest rate spread for banks, limiting their profitability. In contrast, a steepening yield curve implies a wider interest rate spread, potentially boosting banks' NII and overall profitability.

Yesterday's financial reports from Wells Fargo and JP Morgan highlighted margin pressures due to the challenges posed by an inverted yield curve. The strain on margins has led to a slowdown in lending to the real economy, with both banks experiencing contraction in their loan books, posing risks to economic growth prospects. Banks have faced difficulties as customers shift cash into higher-yielding instruments, compelling them to pay higher rates for deposits, squeezing margins and limiting profitability

The market, in turn, responded nervously to the news, reflecting concerns over the compounding stress faced by regional banks due to margin pressures and reduced lending activity. Fears of heightened financial strain and potential spillover effects on the banking sector led to increased volatility and caution among investors, impacting stock prices and market sentiment. This analysis underscores the challenges faced by banks in navigating the complexities of yield curve dynamics and the implications for their role in supporting economic growth through lending to businesses and consumers. But that's go deeper down the rabbit hole and try to understand the economic data.

Understanding the CPI Data

When we take a nuanced approach to the data, we can shed light on why the inverted yield curve is a reflection of contraction pressures in the real economy. This key economic indicator is occurring against the backdrop of clear signs of contraction in the general economy, with implications for financial stability, regulatory responses, and market dynamics. Explaining why the Federal Reserve is in such a hurry to cut rates , even though their mandate would suggest they should, leave rates at current levels.

The empirical evidence reveal a correlation between the inverted yield curve and challenges faced by banks in maintaining profitability. This disruption is exacerbated by broader economic contraction, as evidenced by the collapse in Orderly Liquidation Value (ODL), reflecting a slowdown in economic activity. By ‘Friedman’s evidence, the likelihood for a successful outcome of a soft-landing for the Fed and thus the United States is low.’ This is because the weakness in deposit velocity will serve to reinforce the extreme contraction in deposit growth. The impact ripples through the financial system, affecting the velocity of liquidity in the real economy.

The contraction in the real economy is evidenced by the decline in full-time employment, with the chart above highlighting a loss of over 1 million jobs. The recent layoffs of thousands of truck drivers , further signal a contraction in consumer spending, amplifying the economic slowdown. These factors contribute to increased uncertainty and risk aversion among market participants.

Inflation dynamics, as reflected in the Consumer Price Index (CPI) over the last three months, have been ‘Sticky’, as highlighted by the chart above, where core inflation, less food and energy is still high at 5.17%. However, we must understand that CPI always lags behind the Producer Price Index (PPI).?

This is because the contraction in manufacturing has not been felt in the real economy and in fact, I feel the current sticky CPI, is due to consumers not having adjusted their spending patterns, leading to a short-term distortion in CPI.?

However, the impending impact of full-time job losses on the real economy should, in my opinion, trigger a reversal in CPI inflation. These interconnected developments underscore the interplay between economic indicators, financial market disruptions, and the implications for inflation and economic growth and unfairness, go a long way in explaining why the Federal Reserve and other central banks around the world are in such a hurry to cut.

Fisher's concept of a debt spiral

We are entering a critical phase that echoes the insights of economist Irving Fisher's concept of a debt spiral , characterised by a concerning trend in the US debt-to-GDP ratio reaching 120%. This high level of debt relative to the size of the economy poses risks and challenges that could lead to a debt crisis scenario if not managed effectively.

One key concern is the potential impact of increasing interest rates in this context, as they can exacerbate the debt burden and create inflationary pressures. When interest rates rise, the cost of servicing debt escalates, putting further strain on government finances and increasing the risk of default. This can set off a chain reaction where higher debt payments lead to more borrowing, further raising the debt level and interest burden. This is because the short-term Treasury bills, which Treasury Secretary Yellen, is currently using to pay for most of the US's fiscal obligations, are themselves a source of liquidity and can have a huge impact on the velocity of money.

The inflationary implications of rising interest rates are significant. As borrowing costs increase, businesses may pass on these expenses to consumers in the form of higher prices for goods and services. This upward pressure on prices contributes to inflation, eroding the purchasing power of consumers and potentially leading to a cycle of rising prices and interest rates.

In Fisher's debt-deflation theory, an increase in debt levels coupled with deflationary pressures can trigger a downward spiral of economic contraction, debt defaults, and falling prices, in the long-term. This scenario is particularly concerning when debt levels are high, as it magnifies the risks associated with rising interest rates and inflation.

In the current economic landscape with the US debt-to-GDP ratio at 120%, the potential for interest rate hikes to become inflationary adds a layer of complexity to the challenges faced by policymakers and economic actors. Balancing the need to manage debt sustainability, control inflationary pressures, and support economic growth requires prudent fiscal and monetary policy decisions to navigate away from the looming debt spiral and ensure stability in the financial system and broader economy.

Conclusion

The enigmatic nature of inverted yield curves serves as a profound lens through which to examine the intricate tapestry of challenges and opportunities that unfold within the realms of banking, economic policy, and financial dynamics. This phenomenon not only reverberates across banking operations, Federal Reserve strategies, and economic indicators but also intricately weaves together a narrative of complexity that requires astute navigation by all stakeholders involved.

I hope that through this detailed dissection of the impact of inverted yield curves on banking profitability metrics and lending behaviour, coupled with insightful regression analyses and real-world examples from key players like Wells Fargo and JP Morgan, I have shown that the implications reach far beyond mere financial implications. The challenges faced by banks in interpreting yield curve dynamics and their subsequent effects on economic growth and stability underscore a profound interplay between financial markets, economic indicators, and policy decisions.

As we juxtapose the current economic landscape against the backdrop of historical events like the dot-com bubble and the GFC, parallels emerge that shed light on the potential risks and complexities at play. The lingering effects of the GFC, exacerbated by artificially low rates and housing market bubbles, serve as cautionary tales that resonate with the present-day fragilities in the CRE market. Investors and policymakers alike must heed the lessons of history and interpret the signals from the inverted yield curve with meticulous attention to inform their strategic decisions moving forward.

In a world where the US debt-to-GDP ratio looms large at 120%, the spectre of interest rate hikes potentially fueling inflation adds yet another layer of complexity to the equation. Striking a delicate balance between debt sustainability, inflation management, and fostering economic growth mandates a judicious approach to fiscal and monetary policies to avert the pitfalls of a looming debt spiral and to safeguard stability in the financial system and broader economy.

Thus, the intricate web of interconnected factors at play - from historical echoes of the GFC to the enigmatic signals of the inverted yield curve - demands a nuanced and multifaceted approach from all stakeholders involved. Navigating these complexities requires a comprehensive understanding of economic indicators, financial market dynamics, and policy responses to chart a prudent course forward amidst uncertain terrains and emergent challenges.