US Yield Curve Now Flat Between 12months LIBOR And 10yr Treasury: US Banks Do Not Flinch, Yet by Francesco Filia, Fasanara Capital

12-months US Libor squeezed higher in anticipation to changes in US regulation on prime money-market funds, kicking in on October 14th. Critically, it is unclear whether such technical factors will fade, partially or in full, once the new regulation kicks in and uncertainties clear. Coincidentally, rates on short-dated govies also moved higher in past weeks in anticipation of potential rate hikes by the FED.

In addition to the tighter financial conditions in the inter-banking market that the squeeze on swap rates implies, to domestic and foreign users (as also reflected by TED spreads and OIS/Libor spreads being the widest since 2011), we note that Libor rates are now close to long dated US rates, resulting in a much flatter yield curve.

Interestingly, the US yield curve is now flat between 12months Libor and 10yr Treasury yield,  for the first time since 2008.

CHART of Generic US 10yr yield vs. 12m US LIBOR

Yield Curve, LIBOR, US Treasury

The funding squeeze on Libor rates might prove temporary, but even then the US curve remains very flat: the spread between 10yr US Treasuries and 2yr US Treasuries is the tightest in years (at ~80bps) and on a multi-years declining path.

The shape of the yield curve is a major driver of profitability for commercial banks: the flatter the curve the least profitable its traditional core business of borrowing short-term/lending long-term.

The low level of interest rates is a major driver of profitability for all banks, not just commercial.

Banks’ main commodity is interest rates, so much as oil is the main commodity for oil companies: the lower the level of interest rates the least profitable its core and non-core businesses (fees, carry, bid-offers, trading, liquidity providing are all affected).

Needless to say, Japanese and Core European curves are totally flat when not inverted, and all of that happening while in negative territory: banks there trade at historical lows, in stark contrast to US Banks (some of which are interestingly trading at historical highs).

CHART of Ratio of EU banks / Eurostoxx vs. German yield curve (10yr Bund – ECB Refi rate)

Yield Curve, LIBOR, US Treasury

CHART of Ratio of Japanese banks / Topix vs. Japanese yield curve (10yr JGB – Japan Overnight Rate)

Yield Curve, LIBOR, US Treasury

Our thoughts on European banks and the impact of negative rates are available HERE.

At negative rates, banks’ business model becomes unsustainable. If rates are negative for long enough, the business faces a life threat.

Other factors (Fintech, over-regulation, etc..) are second order drivers, though all headwinds at present times.

In truth, the business models of pension plans, insurance companies, money managers are all affected by what happens to the yield curve, in different ways. But nobody like a Bank is so inescapably impacted by its shape.

At times, good Banks can skilfully outperform their core commodity – the yield curve – and smoothen its widest gyrations across the cycle. Like a good oil company can diversify and smoothen the violent swings of oil prices. But can they totally disconnect from it? Unlikely.

CHART of Ratio of US banks / S&P  vs. US yield curve (10yr US Govt yield – FED Fund Rate)

Yield Curve, LIBOR, US Treasury

Unsurprisingly then, the US Banking sector tends to outperform the broader market during periods of steep and steepening yield curves (chart above). Currently, US Banks are way more expensive than what a flat curve would suggest.

Francesco Filia

CEO & CIO of Fasanara Capital ltd