Last week, the US yield curve steepened to its biggest spread in three decades, creating an environment ripe for profitable lending.
If today's banks take advantage of this global trend, the resulting increased lending could bolster economic activity.
Though a steep yield curve is generally good for the economy and for banks' bottom lines, enhanced bank profits aren't necessarily a boon for Financials stocks due to numerous risks.
However, one sector's stock struggles won't hold back the overall market—especially if lending activity goads business activity.
Bankers have a lot to contend with these days—not the least the US president calling them fat cats. Sticks and stones may break bones, but words will not necessarily goad banks into lending. However, something else might. Last week, the US yield curve steepened to its biggest spread in three decades, creating an environment ripe for profitable lending.
The yield curve measures the distribution of interest rates for same-quality instruments over a variety of borrowing terms. Typically, shorter-term interest rates are lower than long-term rates, creating an upward sloping curve. The greater the spread between short and long-term rates, the steeper the curve—and the bigger profits banks can make by borrowing short-term funds and lending them out on the longer end.
If today's banks take advantage of this trend, the resulting increased lending could bolster economic activity—"suave" entreaties unnecessary. But don't fail to think globally: Encouragingly for the global economy, yield spreads in Japan, the UK, and Europe have similarly widened.
Though a steep yield curve is generally good for the economy and for banks' bottom lines, enhanced bank profits aren't necessarily a boon for Financials stocks. Financials globally still face risks on a number of fronts, including share dilution (Citigroup's program to repay TARP funds), compensation limits (Bank of America's struggles to find a new CEO), regulatory controls (the UK's 50% tax on bonuses greater than £25,000), and sentiment (investors tend to keep fighting the last war, at least until there's another major battle). However, one sector's stock struggles won't hold back the overall market—especially if lending activity goads business activity.
Today's low short-term rates are a result of easy monetary policy, and major central banks globally have voiced intent to maintain such policies for a while yet—giving banks plenty of time and incentive to lend on profitable terms. There are worries the steepening US yield curve also indicates long-term economic prospects are poor—that long-term loans are commanding higher interest rates due to perceived risk. However, long-term bonds have never predicted stock market or economic direction—they reflect today's still-shaken sentiment. And though longer-term rates are relatively higher, they remain historically benign.
Financials are increasingly affirming they are in healthier positions, and today's yield curve environment makes it easier for them to start moving from defensive to offensive—which should benefit a recovering economy.