Understanding Yield Curves

What the Yield Curve Does (and Doesn’t) Tell Us

A very informative write up on Yield curves.

" History suggests that the odds of recession increase when the yield curve spread flattens or becomes inverted. But past recessions only occurred with a high frequency after the curve inverted by a significant amount for a sustained period of time. Further, the yield curve spread can invert for reasons other than the possibility of slower economic growth. We have presented some of these possible explanations, which include expectations of lower long-term inflation, a recent reduction in the term premium, strong demand for longer-term debt by foreign central banks, and investment activities by pension and hedge funds. As a result, the flat yield curve spread may not be signaling increased odds of a recession at present. By the same token, the structural forces holding long-term interest rates down may be with us for some time, even as the cyclical increase in short-term rates subsides. The presence of these structural forces suggests that a flat yield curve could persist for some time.

Similarly for banks, flat or inverted yield curves have historically been associated with narrowing NIMs and lower earnings. Many smaller banks thus far have been able to insulate themselves from changes in the yield curve spread, because they have only slowly raised the interest rates they pay on their liabilities. In contrast, the largest banks have seen their liability costs rise more rapidly, while at the same time their asset yields have lagged those for smaller banks. This situation has resulted in a classic margin squeeze for the largest banks as the yield curve has flattened. Even so, it may be just a matter of time before margins for smaller banks begin to be squeezed, especially if the flat yield curve persists. Regardless of the slope of the existing yield curve—positive, flat, or negative—bankers will benefit from strategies designed to cope with the uncertainty of changing interest rates."