Summary
- US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned being correlated with the short and long ends of the Treasuries yield curve.
- Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit financially from the difference.
- Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.
- If we look at data from the past 5 years, however, the opposite has happened. As the yield curve has flattened, bank stocks have gone up.
Yield curve flattening and US bank stocks
US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned by the banks being correlated with the short and long end of the yield curve. Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit from the difference. Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.
The figure below shows, at the top, the difference in yields for 10-year and 3-month Treasuries for the past 5 years. The two graphs at the bottom show the stock prices for two banks: JPMorgan Chase, representing multinational investment banks; and U.S. Bancorp, representing regional banks. The sources for the graphs are Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ).
As you can see, prior to COVID there seems indeed to be a correlation between US bank stocks and yield curve flattening. However, it is the opposite of what we would expect. The correlation is negative. As the curve flattens, bank stocks go up. In other words, US banks tend to do well in response to what could be seen as a major obstacle to profitability.
What is happening? Compensatory adaptation
As the yield curve flattens, US banks react in a compensatory way – e.g., by resorting to other sources of income. This is compensatory adaption theory at work (, ).
Compensatory adaptation of this type is facilitated by the size and flexibility of the US economy. This makes the environment in which US banks operate significantly different from those of Japan and Europe, where arguably banks have fared worse.
