Recent turmoil in the bond market has put the basic banking business of borrowing short and lending long in a precarious position.
Late last week, yields on 10-year Treasury bonds - the benchmark for many bank loans - were lower than on their five-year counterparts. And yields on five-year Treasuries are barely higher than those for two-year government notes, an indication that the spread between banks' short-term cost of money and the yield on their loans has evaporated.
This inverted yield curve is a dreaded phenomenon in banking.
"You wouldn't want to keep this inversion too long, because that will put pressure on spreads and earnings," said John Otis, an analyst at Bear, Stearns & Co. in New York.
The yield curve, which tracks bond yield versus maturity, normally slopes upward from left to right, from shorter maturities to longer ones. The steeper the slope, the more banks can profit when they borrow funds at low rates and use the money to make longer-term loans. A flatter slope means lower spreads. And a downward slope, an "inverted" curve, means losses.
In Friday trading, the yield on 30-year Treasury bonds was 6.21%; for 10-year bonds, 6.49%; five-year notes, 6.61%; and two-year notes, 6.59%. In other words, the curve barely sloped upward from the two-year maturity to the five-year but then declined sharply, sketching a downward slope.
"Banks need some kind of an upward-sloping curve," said John Kanas, chairman and chief executive officer at North Fork Bancorp in Melville, N.Y. "The flatter it is, the tougher it is to make money."
The furious bond market rally last week was sparked by the Treasury's announcement that it would retire debt by buying back long-term bonds, reducing their supply in the market.
But simultaneously, the yield curve tracking maturities of three- to 10-year securities was being inverted by investors' expectations of more rate hikes by the Fed. Why invest in a five-year note at 6.6%, only to see rates of shorter-term debt surpass that level?
"Right now what the market is telling us is the Fed will be raising interest rates higher and higher," said Sung Won Sohn, senior vice president and chief economist at Wells Fargo & Co.
The Labor Department's employment report Friday did nothing to dispel expectations of more hikes by the Fed. Payrolls in January jumped by 387,000 workers, cutting the unemployment rate to 4%, its lowest rate since 1970.
"The across-the-board strength of the January jobs situation makes another Fed increase in short-term rates all but certain," said Kenneth Mayland, chief economist at KeyCorp.
That kind of expectation will probably keep the yield curve inverted. Some say this would increase the chances of trouble for banks and the likelihood of a recession.
"The longer the inversion stays that way, you are going to hear the R-word more often," said Michael Laliberte, a co-adviser at Imperial Bank Fund, a portfolio managed by the Retirement Planning Co. in Providence, R.I.
On the brighter side, the recent behavior of the yield curve indicates that this period of rising rates might be near an end. A similar situation occurred in 1994 and early 1995 when the Fed, in a yearlong series of hikes, raised short-term interest rates by three percentage points. Though the curve inverted for a period, the economy did not grind to a halt.
"When you examine the history, there is a solid reason to believe that kind of interest rate peak is in sight," Mr. Mayland said. "When you have an inverted curve, the end of the rise of interest rates is somehow in sight."
And while short-term rates climb, banks that have fared well recently in terms of interest rate margins may be better off. Banking companies such as Detroit-based Comerica Inc. and Milwaukee-based Firstar Corp. reported fatter margins in the fourth quarter, while those of most companies declined. Comerica benefited from the growth of high-margin commercial loans. Firstar has insulated itself from rate hikes by relying primarily on its low-cost deposits to fund loan growth.
"The best protection is the makeup of the funding base," said David Moffett, chief financial officer at Firstar. "As a result, we don't have to rely on hedging as much."
Just looking at bank balance sheets won't tell investors how well banks are hedged from rising rates. Companies are not required to disclose hedging positions. But banking companies that rely heavily on wholesale funding should have been covering their exposure six months ago, said Mr. Kanas of North Fork.
"You can hedge now," Mr. Kanas said. "But it's a little late. It's expensive to buy derivatives now that rates have been going up."
