WSJ Yield Curve Article 080905

Fed's Fight Squeezes Banks, Spooks Markets

Vanishing Gap Between Rates For Long- and Short-Term Debt Means Lower Profits for Lenders

By MARK WHITEHOUSE and ROBIN SIDEL
Staff Reporters of THE WALL STREET JOURNAL
August 9, 2005; Page C1

The Federal Reserve's campaign to tame inflation has created an investment rarity -- a "flattening" yield curve -- that is squeezing banks and Wall Street firms, and which in the past has presaged economic downturns.

As the Fed prepares today to raise its short-term interest-rate target for the 10th consecutive time in 14 months, to 3.50%, long-term interest rates remain stubbornly low, although they have risen in the past few weeks. That has some market watchers predicting that the difference between short and long rates -- known as the yield curve -- will disappear by year end. Under that scenario, consumers and companies would end up paying the same rate for short- and long-term loans, from certificates of deposit to long-term bonds.

A flattening yield curve removes banks' age-old profit model: Borrow money at low short-term rates and lend it out to people and companies at higher long-term rates. Already, as rates converge, banks are cutting costs to address their shrinking profit margins. "Banks are scrambling, because they have this huge amount of income that is disappearing that they need to replace," says William S. Demchak, chief financial officer of PNC Financial Services Group Inc.

Should the curve end up "inverting" -- with short rates climbing above long -- banks could lose their incentive to lend. That is one reason previous flat yield-curve inversions have signaled recessions, though some economists think this time will be different. Now, they say, falling long-term rates have offset the braking effect of the Fed's short-term rate increases, in what traders call a "bull flattening": People and companies are able to bypass banks and secure low, long-term rates from other lenders or even through the bond market, meaning they still are able to make big-ticket purchases, including that new home or factory.

"It matters a lot to Wall Street, but it's not necessarily a bad thing for Main Street," says Jim Bianco, president of Bianco Research LLC, an independent research firm based in Chicago. Rising short-term rates also boost the return on extreme short-term investments such as money-market funds -- good news for folks on fixed incomes.

When the Fed began raising rates in June 2004, the difference in yield between the two-year and 10-year Treasury notes -- one measure of the yield curve -- stood at about 1.90 percentage points. As of yesterday, it had fallen to about 0.27 percentage points, well below the historical average of 0.75. Many expect it to shrink further. In a recent poll conducted by the Bond Market Association, a trade group, 12 big Wall Street banks and securities dealers forecast, on average, that the spread would fall to 0.15 percentage points by the end of this year.

The 10-year Treasury note finished trading in New York at 97 20/32, down 8/32, or $2.50 per $1,000 in face value, to yield 4.426%. The 30-year fell 8/32 to 111 19/32 to yield 4.599%.

Economists' explanations for what is happening to yields vary, many amounting to too much money chasing too few long-term investments, pushing prices up and potential returns down. Asian central banks and private investors, for example, have been big buyers of U.S. bonds. And as the U.S. population ages and the government prods companies to better fund their pension plans, demand has grown for the kind of long-term bonds that can guarantee payments to future retirees.

But the Fed's own actions also have played a leading role in keeping long-term interest rates low. Over the past year, the Fed has been unusually open about signaling its intentions to the market before each of its short-term rate increases. The predictability of Fed policy has calmed peoples' worries that a sudden increase in inflation could erode the value of their investments, making investors more willing to part with their money longer, for little extra return.

It has also encouraged investors to take on more risk -- for example, by buying long-term bonds with money borrowed at short-term rates. In one indication of investors' rising tolerance for risk, securities dealers' outstanding short-term loans to their clients reached an all-time high of $3.5 trillion at the end of June, though it has decreased somewhat since.

If strong economic data -- or some shock such as a sudden rise in inflation -- prompt investors to sell bonds purchased on borrowed funds, long-term interest rates could jump. For now, though, added demand for long-term bonds is pushing prices up and interest rates down, undermining the Fed's ability to influence long-term rates.

If the yield curve keeps getting flatter, Wall Street would find itself in an uncomfortable spot: As banks and hedge funds face higher borrowing rates and lower returns on longer-term investments, they are tempted to take greater chances to boost income. "It's a bad scenario," says Geoffrey Gwin, portfolio manager at Group G Capital Partners LLC, a hedge fund based in New York.

Banks, certainly, have blamed the yield curve for lackluster second-quarter results. "I will be candid with you that the yield curve year-to-date has certainly flattened more than we looked for....So that has in turn impacted the results," Sallie Krawcheck, chief financial officer of Citigroup Inc., told investors and analysts on a conference call last month.

Among big banks hardest hit were Bank of America Corp., North Fork Bancorp and J.P. Morgan Chase & Co, according to an analysis conducted by Andrew Collins, who follows banks at Piper Jaffray & Co. in New York.

To soften the pain of the flattening yield curve, banks are slashing costs and taking other steps to increase earnings. Last month PNC, Pittsburgh, announced a cost-cutting plan aimed at saving $300 million by cutting 3,000 jobs, among other actions. Wachovia Corp. and National City Corp. also are cutting jobs and costs. And banks are setting aside less in reserves to cover bad loans, a practice with which they feel increasingly comfortable because corporate and consumer bankruptcies remain at historical lows. The strategy could backfire, however, if credit quality begins to deteriorate.

Some economists say the financial sector's pain could spread to the rest of the economy, tipping it into recession. David Rosenberg, chief U.S. economist at Merrill Lynch, notes that U.S. corporations derive about one-third of their earnings from financial activities, and that previous flat yield curves have presaged economic downturns.

Financial companies' travails, however, need not affect the economy as much as they have in the past, says Ethan Harris, chief U.S. economist at Lehman Brothers in New York. Banks are still lending, and even if they weren't, companies and consumers can turn to the bond markets, with their low long-term rates, for cash. "Who cares about banks?" Mr. Harris says. "As long as they're loosening lending standards, the fact that they're getting squeezed a bit doesn't matter for the economy."

Treasurys

Treasurys prices fell, in part on a lackluster three-year note sale, but declines were limited by caution in advance of today's Federal Reserve policy meeting.

The Treasury sold $18 billion of notes at a high rate of 4.204%, above a pre-auction level of 4.20%. Although one gauge of demand, the bid-to-cover ratio, was viewed as respectable, demand from people other than primary dealers totaled just 28%, compared with an expected level of around 40%. The Treasury's $44 billion quarterly refunding includes two more auctions: $13 billion of new five-year notes tomorrow and $13 billion of new 10-year notes Thursday.

[10-Year Treasury Note Yield]

[Sinking All Boats]