The U.S. bond market just flashed a key recession warning, but banks and their investors still have a rosy view of the world. Higher interest rates and a return to growth in lending are expected to bolster profits this year and next.
The red flag from bonds is the so-called inversion of the yield curve, where short-term Treasury yields are higher than longer-term ones, indicating that investors expect lower interest rates, inflation and growth in the future. A curve upward from low yields now to higher ones in the future suggests the opposite.
Two-year yields briefly climbed a fraction of a basis point above 10-year yields on Tuesday, inverting that part of the curve for the first time since August 2019. This has often been a signal of impending economic downturns in the past, although some investors and economists say the gap between three-month and 10-year yields is a better guide—and that is far from inverting.
Clearly, if the U.S. does dip into recession, banks will take a hit. But will it? Economists so far are only placing a 20% chance on that outcome in the next year. Indeed, if a recession materializes, there’s some reason to think it may not happen until next year or 2024 as the consequences of the Federal Reserve’s fight against the worst inflation in 40 years take time to transmit to the real economy. Yield curves have a habit of being very early to call recessions, as was the case in the late 1980s and ’90s.
Economic data and corporate earnings have mostly held up, but the market still has scant evidence about how consumers have fared in the past month as gasoline prices soared and the cost of many types of borrowing skyrocketed. In the past week, housing data has contributed to slight downward tweaks to growth expectations. Meanwhile, the Chicago Fed’s advance retail trade summary—based on high-frequency indicators including credit card activity, foot traffic and sentiment—projected that retail and food services sales excluding autos will decline 3.2% in March from February, a 4.4% drop on an inflation-adjusted basis. Mostly, though, the fear is that increasingly aggressive monetary policy tightening will prove to be the 18-wheeler that breaks the camel’s back.
Bank profits are linked closely to interest rates and economic growth: Lending helps drive the economy forward, and higher rates make loans more profitable. The yield curve is still widely noted as a proxy for bank profitability based on the idea that banks use cheaper short-term deposits to fund long-term loans. They rake it in and bank stocks should rally when the curve is steep and slash lending when recession looms.
Indeed, the Fed’s survey of bank loan officers shows they tightened lending standards after the yield curve inverted in the late 1990s, ahead of the 2008 financial crisis and even in 2019. But right now, banks are lending freely, and their stock prices are rallying even as the two- to 10-year yield curve has collapsed. In fact, U.S. bank stocks have tracked 10-year yields at least as much as they have tracked the spread between two- and 10-year yields for much of the past 20 years.
Part of the reason is that the simple model of banking described above is outdated, especially in the U.S. Banks create loans but sell many of them swiftly into capital markets: Mortgages go into mortgage bonds; lots of credit card debt and car financing goes into securitizations; and large companies mainly borrow longer-term debt directly from bond markets.