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How The Yield Curve Works To Regulate the Financial Services Industry

2023-04-28

How does the US Federal Reserve’s policy of raising short-term interest rates affect the economy?

Amid a perfect economic storm, many small, un-hedged financial institutions are under extreme stress because of dramatic swings in government policy throughout the ‚Äėsickness‚Äô economy. This blog post aims to provide insights into the background and rationale behind the current situation in the financial services sector.

Background & Overview

  • ‚ÄčWhen the health crisis emerged in March 2020, the US Federal Reserve Board lowered short-term interest rates to near-zero levels.
  • ‚ÄčThe US Federal Government injected billions of dollars into the economy through corporate bailouts and direct payments to citizens (Stimulus ‚Äėstimmy‚Äô checks).
  • ‚ÄčThis influx of cash led banks to see substantial growth in their deposits, leading to them investing in US Government Bonds, enjoying easy profits from the spreads.

As a result, financial institutions found themselves in a precarious position because of a fast-changing environment.

Central Banks and Monetary Policies

  • ‚ÄčIn early 2020, central banks worldwide lowered short-term interest rates in response to the perceived health crisis.‚Äč
  • ‚Äč‚ÄčMany governments injected money into their economies through massive stimulus packages, fueling inflationary pressure.
  • ‚ÄčThe sheer magnitude of policy shifts has led to significant problems within the financial services sector, as short-term interest rates experienced unprecedented changes.

The US Federal Reserve Board’s actions have played a role in the current turmoil. In this blog post, we will explore the implications of these policies for the banking system and how various market participants are feeling the impact today.

US Bank Deposits Growth

Figure 1.b: US Bank Deposits Growth

This image shows the increase in US bank deposits since the Dot-com bubble in 2020. As baby boomers retired, they converted their stocks into cash, leading to a significant spike in deposits. This trend aligns with the 80-year money cycle.
Reserve Lending Framework

Under the reserve lending system, banks use customers’ deposits to buy long-term US treasuries. As deposits grew over the past 40 years, bond purchases increased, leading to higher bond prices and falling yields (see Figure 1.c below). They expected banks to hedge any risks if interest rates rose when borrowing at low short-term interest rates to meet customer demand.

The Fed Put gave assurance that yields would stay low. However, the cycle of lower rates and higher bond prices seems to have ended, signaling a potential trend of higher yields and lower bond prices for the next 40 years.

Reserve Lending Regime Simplified

  • ‚ÄčCustomers deposit savings into banks
  • ‚ÄčBanks use those funds to buy long-dated US treasuries
  • ‚ÄčThis trend caused higher bond prices and falling yields over the past 40 years
  • ‚ÄčBanks borrowed at short-term interest rates to meet customer demands
  • ‚ÄčThe Fed Put made it so this trend stays the same.

Bond Prices & Yields

Figure 1.c: Bond Prices & Yields

This image shows US government bond prices and yields through the TLT ETF, which holds 20-year maturity US Government bonds.

Bond prices change to reflect market expectations about inflation and the issuer’s ability to repay debt. Higher yields show higher inflation expectations, while lower yields suggest lower inflation expectations.

  • ‚ÄčTLT is an ETF holding US government bonds with average maturity of 20 years
  • ‚ÄčBond prices change in the market to reflect higher or lower yields
  • ‚ÄčHigher yields show higher inflation expectations, while lower yields show lower inflation expectations

Yield Curve Changes Explained

The health crisis affected the yield curve. During this time, short-term borrowing costs were almost zero, leading to a respectable spread between short and long yields. This ensured bank profit margins and encouraged banks to lend reserves.

The US Federal Reserve Board even allowed banks to buy long-dated US treasuries without limit, taking reserve requirement ratios close to zero. This trend of rising bond prices and falling yields went parabolic, signaling an end to the trend.

The following factors have altered the yield curve.

  • ‚ÄčThe health crisis played a significant role in long-term interest rate cycles.
  • ‚ÄčShort-term borrowing costs were close to zero during the crisis, ensuring bank profits.
  • ‚ÄčThe US Federal Reserve Board's encouragement of immense US treasury acquisitions induced banks to be more discerning with lending.
  • ‚ÄčThe 40-year trend of increasing bond prices and falling yields reached a turning point.

Key Moments in the Yield Curve:

Figure 1a. the Yield Curve has changed dramatically

1. Normal Yield-Curve (April 2020)

  • Banks buy long-dated US government bonds, ensuring profits [A less than B].
  • Small profits for financial services, meeting the government‚Äôs liquidity needs.

2. Normal Yield-Curve (November 2021)

  • Health crisis nears an end, US Federal Government stimulus fuels inflation
  • The Federal Reserve Board hesitates to reverse zero policy, leading to rising long yields and trapping banks in long-dated purchases.
  • ‚ÄčBanks make profits [A is less than B], yet face hedging challenges.

3. Inverted Yield Curve (March 2023)

  • Government overspending and easy monetary policy cause inflation and monetary crisis
  • A sharp increase in short rates leads to guaranteed losses [A is greater than B].

Riding the Yield Curve rollercoaster

Understanding The Yield Curve Shift

Borrowing short-term results in cost losses; liquidating invested capital implies long-term capital losses.

Understanding the shift in the yield curve helps us recognize the impact of the health crisis, government policies, and the changing financial landscape on banks and their profit margins.

The Fed Spread

(Figure 1.e.2) The Fed Spread: Short-term Interest Rate Market Panic

The ‚ÄúFed Spread‚ÄĚ is a market-based proxy to measure potential financial crises. It‚Äôs the difference between the current Federal Funds rate and the Eurodollar rate. A reading above 1.00 shows a crisis within the financing sector.

The market experienced a crisis during a healthcare shock and lost faith in the Fed. However, since November 2022, the market has calmed down and returned to a more normal state.

  • The ‚ÄėFed Spread‚Äô measures potential crises in the financial sector.
  • It compares the Federal Funds rate and Eurodollar rate.
  • ‚ÄčA reading above 1.00 suggests a crisis in the financing sector.
  • ‚ÄčThe market was in crisis during the health care shock, but has calmed down since November 2022.

Short-term Interest Rate Market vs. Fed Funds

(Figure 1.f) Short-term Interest Rate Market vs. Fed Funds (Zoomed Out)

  • The 40-year history shows a trend of falling interest rates since 1980.
  • We‚Äôre approaching a transition back to an easier monetary policy environment.

In the past, the central bank maintained a zero-interest-rate policy, and the US government increased fiscal stimulus. The market recovered from the health crisis, and the easy policy led to a return of inflation (Figure 1.d).

Then, the market demanded higher interest rates due to continued inflationary pressures. The decision to calm down yields and raise bond prices depends on the market’s belief in inflation control.

Inflation’s Dramatic Return

(Figure 1.d) United States Inflation Rate YoY

Central Banks will not contain inflation until short-term interest rates are higher than the inflation rate. The two rates are converging, suggesting that the containment event is near.

  • Central banks maintained a zero interest rate policy and increased fiscal stimulus.
  • Inflation returned, and the market demanded higher interest rates.
  • ‚ÄčThe market, not bankers or government officials, will decide when inflation is under control.

To gain insights into long-term market predictions, read our blog post on How the Benner Cycle Predicts 100 Years of Market Movement.

Short-term Interest Rate Market vs. Fed Funds

(Figure 1.e) Short-term interest rate market vs. Fed Funds

  • Eurodollars (orange) and Fed Funds (purple).
  • When the orange line trends down, short-term interest rates go up.
  • ‚ÄčThe market decides the path, not individual participants.

This image shows corporate short-term interest rates (orange) and government-sponsored short-term interest rates (purple line). As the market rate (orange line) goes down, it shows that short-term interest rates are going up. The market always has the final say.

In around 18 months, the Federal Reserve Board has shifted short-term interest rates by over 450 basis points (Figure 1.a right), which will have a major effect on the economy, especially the banking system.

Market-based Inflation/Deflation Proxies, Government Bond Yields, Mortgage RatesSmall Call to Action Headline

(Figure 1.g) Market-Based Inflation/Deflation Proxies, Government Bond Yields, Mortgage Rates

  • The TLT/TIP spread measures investors‚Äô willingness to pay for inflation protection.
  • The chart also includes long-dated US treasuries and US mortgages.
  • ‚ÄčInflation regulation may bring rates back to the mean.

The TLT/TIP spread is an inflation/deflation gauge. A positive spread means investors will pay for inflation protection, while a negative spread shows no need for protection. The chart also includes long-dated US treasuries and US mortgages.

Damned if You Do / Damned if You Don’t

Financial institutions buying low-yielding long-dated government bonds at the health crisis peak now face losses because of higher borrowing rates for customer withdrawal requests. Selling long-dated bonds would also incur significant capital losses. Bond prices have fallen by up to 50%, trapping buyers.

The trend of increasing customer deposits and rising bond prices has continued since the dot.com bubble. The Fed’s relentless market support encouraged reserve lending and government debt market support.

For more information on bond prices, yields, and their impact on the financial services industry, check out our blog post on What Is a Bond and How Do They Work?

(figure 1.h) Elliptical planetary orbit

The Orbit of Planets is Elliptical, not Circular

The Earth‚Äôs orbit around the Sun is elliptical, reflecting a whip-saw effect at the extremes of each cycle. We see this behavior in long-term asset cycles and ‚Äúparabolic‚ÄĚ moves in asset prices.

Normalization of the Interest Rate Market

  • The interest rate market is moving back to normalcy after extreme lows.
  • The next 20 years will involve resetting the system to normal conditions.

As prices rose during the cycle peak, the move back to normalcy is just as dramatic. We are now witnessing substantial losses on the other side of the cycle pivot. The system will spend the next 20 years resetting to normal conditions.

Conclusion:

In this blog post, we explored the profound impact of the health crisis, government policies, and changing financial landscape on the yield curve, banks, and their profit margins. Key takeaways include:

  • The health crisis affected the yield curve, leading to changes in short-term borrowing costs and bank profit margins.
  • Central banks worldwide lowered short-term interest rates in response to the crisis, leading to massive stimulus packages and inflationary pressure.
  • ‚ÄčThe yield curve has experienced dramatic shifts, signaling the end of the 40-year trend of rising bond prices and falling yields.
  • ‚ÄčThe market, not individual participants or government officials, determines the path of interest rates and inflation control.
  • ‚ÄčFinancial institutions face substantial losses because of higher borrowing rates and falling bond prices, leading to a normalization of the interest rate market over the next 20 years.

Understanding these changes in the yield curve and their implications for the financial services industry help you navigate the developing economic landscape. For a more in-depth understanding of these financial forces, jump into the Level 1 program at TRI and become financially literate so you can use this knowledge to your advantage. Click here to enrol in the TRI Level 1 program.

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