Long-term interest rates are rising. The current yield on the 10-year Treasury note is 0.96%, which is its highest level since mid-March. Short-term interest rates, on the other hand, remain at very low levels because they are more directly controlled by the Federal Reserve. The Fed has committed to keeping short-term interest rates very low indefinitely in response to the threat of COVID-related economic pressures. As a result, the yield on the 3-month Treasury bill, for example, is currently just 0.08% – not much different than where it’s been since March when the Fed cut a key short-term interest rate (the Fed Funds rate) back to zero. The move higher on the long end of the yield curve without much movement on the shorter end has resulted in a widening in yield spreads. That simply means that investors in Treasury bonds are able to earn significantly higher yields if they are willing to buy bonds with longer durations. That hasn’t always been the case. For much of 2019 and briefly in early 2020, investors were able to earn a higher yield on a 3-month Treasury bill than on a 10-year Treasury note, a situation referred to as an inverted yield curve. Now, the difference in yields is about +0.87% in favor of the 10-year bond, offering a better return to investors willing to tie up their money for longer. That difference may not seem like a lot, but certain sectors of the economy are big beneficiaries of this “steepening in the yield curve.”
The beaten-down banking sector, which has shown signs of life in recent weeks, has most to gain from rising long-term interest rates and a steepening yield curve. Investors have been quick to respond. After banks stocks plummeted in response to the COVID crisis in February and March and then dramatically lagged the overall market during the recovery, the KBW Bank Index is up some 34% since September 23. The recent strength in bank stocks can be attributed to several factors, including the successful discovery of at least three COVID-19 vaccines, falling unemployment, a better economic outlook, and just ultra-cheap valuations. But the biggest factor, in my opinion, has been the changes in interest rates. Banks make money by taking deposits, paying interest on those deposits (which is generally tied to short-term interest rates), and deploying the cash into loans, a large portion of which carry fixed rates based on longer-term interest rates. Given the importance of net interest income, or spread income, to bank profitability, it shouldn’t be a surprise that this heretofore “left-for-dead” sector has finally started to perk up. The chart below shows that bank stocks have been highly sensitive to yield spreads since April, a period during which the 10-year Treasury yield and the yield spread both increased 0.36%-0.37%.
Falling yield spreads have been a big drag on bank profitability for many years. As an example, Wells Fargo is a large bank that earns a big share of its income from spread lending, and so it has been particularly impacted by lower spreads (as well as some self-inflicted mistakes). The company reported $30.9 billion of net interest income on average earning assets of $1.8 trillion for its first three quarters of 2020. On an annualized basis, that works out to a net interest margin of 2.32%. Back in 2010-2015, when the yield spread between the 3-month Treasury bill and the 10-year Treasury note generally hovered between 2% and 3%, Wells Fargo’s NIMs were running anywhere between 3.0% and 4.3% on an annualized basis. The following chart shows the toll that falling yield spreads have taken on WFC’s net interest income over the past decade. There are no doubt other factors at play, but a near halving in the bank’s NIM over 10 years is attributable, in large part, to the drop in interest rates and the decline in yield spreads.
Will yield spreads continue to widen, extending a much-needed tailwind to bank profitability? It’s certainly possible. The Fed is nowhere close to raising interest rates, especially as Congress is unable to agree to another round of COVID-related economic stimulus. At the same time, the markets are beginning to price in the likelihood of a much stronger economy in the second half of 2021 after the vaccines becomes widely administered. It may be a delicate dance to the finish, but if the Fed is able to provide a short-term lifeline to the other side of COVID, bank stocks could still have significant upside. At the very least, they should not have to continue fighting the unrelenting long-term trend of falling yield spreads for too much longer.