And now for something completely different. Except it’s not; it just hasn’t been around
for a number of years. But it most assuredly has an impact on your community bank’s
bond portfolio and on the securities you’ll be thinking about purchasing the next time
you’re in the market.
I’m speaking once again about the ever-popular slope of the yield curve. For our
purposes, these are the yields on the various on-the-run Treasury issues, specifically the
ones at the two-year and 10-year maturity terms. Those are the most popular benchmarks
for bond market analysts to use when the slope of the yield curve is discussed.
What is different so far this year is that the slope, or difference in yield at the
benchmarks, has both grown and shrunk in a few short months. This surely doesn’t look
like a secular trend vis-à-vis 2017 through 2019, when the slope gradually, grindingly,
flattened by more than 100 basis points (1.0%). So, now that we’ve established that bond
yields of differing tenors seem to have minds of their own, what does that mean to your
More is better, usually
Most community bankers have been wishing for higher rates since late 2019, when the
economy started to lose oil pressure. Loan demand (but not credit quality, thankfully) had
already begun to deteriorate by the time “COVID-19” became part of our vocabulary. In
short order, the Federal Reserve pushed short-term yields to near zero, began buying
billions of bonds each month and launched a series of programs to back-stop the
economy. The yield curve and—not surprisingly—net interest margins flattened.
What we experienced in the first quarter of 2021 is known as a “bear steepener.” This
occurs when monetary policy is on hold at the same time bond investors get the shakes
about inflation. With all the fiscal stimulus coursing through the economy’s veins, long-
term buyers demanded more protection against purchasing power erosion, and the slope
of the curve jumped nearly 80 basis points by March 31. Alas, this trend proved to be
In the second quarter, especially after the Fed’s June meeting, the bond market gave back
a large portion of the 2021 yield improvement. By the halfway point in the year, the
curve’s slope was back down by about 35 basis points. This was not welcome news for
portfolio managers, who are still hustling to invest idle cash, which is probably leaving
margins exposed to falling rates.
What shape indicates
This is probably a good time to recount what the slope of the curve telegraphs about
investor sentiment. If long and short rates have very little difference, it indicates investors
are relatively satisfied that inflation is not a threat. Two-year buyers will almost always
take their cue from the Fed, while 10-year buyers, who are quick to retreat if they sense
prices are about to rise, have gradually required less risk premium over the past 30 years
since inflation has stayed under wraps. (Investors of a certain age will recall the term
“bond vigilantes.” Those institutional buyers would demand higher yields if the
combination of monetary and fiscal policies weren’t to their liking. In the two decades,
the bond vigilantes have gone the way of Wyatt Earp.)
What took place in June of this year would qualify as a “bull flattener.” Longer rates
retreated when the Fed, and in particular chairman Jay Powell, put the bond market more
at ease regarding incipient inflation fears. The flatter curve means that longer-term
investors aren’t rewarded as much for their additional price risk. That is relevant to
community banks in 2021, since bond portfolios are as long as they’ve ever been, using
duration as an indicator.
Where to go from here
What’s the next move for the shape of the yield curve? I’m not going to hazard a guess,
but I will point out several tidbits of interest. For one, the current slope of about 120 basis
points is almost exactly the past 10 years’ average. For another, the recent yield rise for
the two-year Treasury note also restored its 10-year average spread over Fed Funds.
And finally, the Fed’s June dot plot may have shown that more members are projecting
the first hike earlier than in the recent past, but the consensus is still in 2023, which is a
long way from here. Stay tuned for more reporting on our mountain of debt, as depicted
by the thrilling slopes of the U.S. Treasury yield curve.