Dramatic movements in interest rates have suddenly raised doubts about banks' ability to maintain their profitability.
The yield on the bellwether 30-year Treasury bond slipped to 5.72% by 4 p.m. Tuesday-its lowest since the U.S. government began regular sales of the bonds in 1977.
Banks are thought to thrive in low-interest environments, but the drop in the long bond, while shorter-term rates held relatively steady, suggested that a rare inverted yield curve might be on the horizon.
An inverted yield curve-last seen three years ago-occurs when the yield of long-term Treasuries falls below the yield on the shorter-term securities.
A flat or inverted curve is a bad omen for banks, because it means they cannot make money on the spread between short-term deposits and longer- duration loans.
A sustained inverted yield curve, with the two-year Treasury higher than the 30-year bond, usually means that a slowdown in the economy or perhaps a recession is not far behind.
Small inversions have already occurred briefly across certain segments of the Treasury market. Last week the yield on three-year paper was higher than on five-year paper, and Tuesday the yield on two-year paper was higher than five-year paper.
The inversions were quick and brief. And chief economist Thomas Carpenter of ASB Capital Management, Washington, said Federal Reserve chairman Alan Greenspan's mention over the weekend of deflation could portend a cut in short-term rates by the Fed to keep the yield curve steep.
Lower interest rates and the flat or inverted yield curve both mean risks for financial institutions, said bank bond analyst Eric J. Grubelich of Keefe, Bruyette & Woods Inc.
Thrifts in particular tend to fare poorly with a flat yield curve, because they carry many residential mortgage loans on their balance sheets.
Thrifts have tried to mitigate the risk by offering adjustable rates. But they are vulnerable when rates fall, because lower rates are an incentive to homeowners to refinance their homes with fixed-rate loans.
Mr. Carpenter said that low interest rates and the prospect of an inverted yield curve signal slower loan growth, lower profit margins, and deteriorating credit quality for banks.
As the yield curve flattens, bank stocks, bonds, and other securities get hammered because of earnings fears.
Spreads on trust-preferred securities have already suffered because they are callable instruments which underperform in low-interest rate environments, one trader said.
The rare interest rate environment has prompted some strategists to turn toward alternative securities, said Perry H. Beaumont, managing director of fixed-income at Salomon Smith Barney.
Mr. Beaumont said an inverted yield curve would be unusual at this point, because an inversion is usually preceded by aggressive tightening of credit by the Federal Reserve. Nevertheless, he said, Salomon Smith Barney has been steering clients away from bank bonds and stocks because of the possibility of an economic slowdown.
Mr. Beaumont said that bank bond and stock investors have grown skittish about their investments because of the turmoil in Southeast Asia and declining interest rates.
In the last two days, he has strongly recommended preferred stock because it is a "hybrid security that straddles both the bond and stock market."
Preferred securities trade on the stock market, offer dividends, yet can be callable like a debt instrument.
Other market experts, however, are telling investors to stay firm with their bank investments.
Krishna K. Memani, corporate bond strategist at Morgan Stanley Dean Witter, said an inverted yield curve is unlikely.
"In this environment the bank sector offers tremendous value in the corporate market."
Mr. Memani acknowledged that trust-preferred securities are hurt in this kind of environment but argued that compared with industrial bonds, trust- preferred securities-particularly those issued by regional banks-are a better deal for investors.
