As is well known, the Fed is trying to raise short-term interest rates sufficiently to persuade bond traders that inflationary pressures will be contained, thereby causing them to bid down long-term rates to more modest levels. If the central bank succeeds, the yield curve will have begun its long-awaited flattening. Yield curves generally flatten most when the markets judge that the central bank is acting vigorously to forestall inflation.

But while such a development is good for the overall economy, it is not necessarily good for banks. In fact, for many banks, a yield-curve flattening could prove quite troublesome. First, a lot of banks remain liability sensitive, so a rise in short rates will hurt them. Second, even those that are not liability sensitive will suffer for a reason that is almost always overlooked.

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