Why the flattening yield curve could be a big blow for the banks

Image of financial institutions

It may not have gone negative yet but the yield curve – as measured by the difference in the yield available on ten-year and two-year Government bonds – is as at its lowest level since 2007 in the US, 2008 in the UK and 2016 in Germany.

Whether the yield curve is forecasting an economic slowdown or recession (accurately or not) or whether it is simply anticipating a fresh round of interest rate cuts and Quantitative Easing from nervous central banks remains open to debate. But one thing does seem certain and that is banking stocks do not like what they are seeing from the yield curve.

The yield curve stands at multi-year lows in the US, UK and Germany

Source: Refinitiv data

Banking shares are doing badly not just in the UK but the US and Europe as well – and if there’s one sector that advisers and clients would like to know is in good health after their experiences of 2007-09 it is the banks, so this is a trend that needs to be watched.

Banks have been poor performers in the UK so far in 2019

Source: Refinitiv data. Capital return only. Data to 25 March 2019

Mind the gap

As advisers and clients will know, the yield curve measures the difference between different maturities of Government debt, with the gap between two-year and ten-year paper a common benchmark.

In theory, the yield on the ten-year should always be higher. This is simply because more things can go wrong in the life of a ten-year bond than in a two-year one. Advisers and clients will demand a higher yield as compensation for the higher risks, which, for fixed-income investors, come in the form of default, interest rate movements and inflation.

But sometimes the gap between the ten-year and two-year Government bond yields can narrow. This is often (though not always) because the yield on the ten-year falls quickly as markets price in an economic slowdown or recession and then central banks’ usual response, which is to cut interest rates in an attempt to boost the economy.

At the moment, the yield on ten-year Government Gilts in the UK, Treasuries in the USA and Bunds in Germany is falling faster than the two-year yield, to flatten the yield curve.

As a result, banking shares are starting to struggle on the UK, American and European stock exchanges.

UK banking stocks have lost momentum as the yield curve has flattened …

Source: Refinitiv data

… a trend that has developed in the US since early 2018 …

Source: Refinitiv data

… and became apparent in Europe once the ECB began to taper QE last year

Source: Refinitiv data

The thinking behind this is that a flattening yield curve damages banks’ earnings power.

Banks tend to raise funds by borrowing in the short term and lending over the long term, in what it known as maturity transformation. The idea is that this enables them to borrow at a lower interest rate and lend money out at a higher one, pocketing the difference as their profit – this is their so-called net interest margin.

Thrown a curveball

The problem now is that a flattening yield curve will be weighing on net interest margins. That will leave the banks relying on fees from any wealth management or private banking operations that they might have, or trading commissions and advisory fees from an investment bank, if they are brave and well capitalised enough to own one.

We can already see how the net interest margins at the UK’s Big Five banks have started to come under pressure, or at least stop expanding, and one key test of April’s first-quarter results will be the trend here. Downgrades to net interest margin expectations could well feed into cuts to earnings estimates and no matter how cheap a stock may look on book value, dividend yield or earnings it is generally pretty hard for it to perform, at least in the short term, if profit forecast momentum is negative.

Banks’ net interest margins could feel some pressure in 2019

Source: Company accounts

This does not have to mean the end of the equity bull market. But it is an unwelcome complication, especially for the UK, where banks are expected to make big contributions to profit and dividend growth in 2019 and beyond, and is also a potential warning to central banks that unorthodox policies can have unintended consequences.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.