Reports are coming out that the Italian yield curve has inverted and the Spanish yield curve is flattening.  Why is this important?

To put it in more personal terms, think about what decision you would make when choosing a certificate of deposit for your hard-earned savings.  If you had the option to buy a 10-year CD at 7.32% or a 2-year CD at 7.71%, which would you choose?  In a normal environment, you would want to have a premium for making your money illiquid.  Therefore, you would take the 2-year CD in this case.

Traditionally, banks make their profits from borrowing from the “short end” of the yield curve and lending on the “long end” of the yield curve.  In other words, they take in short-term deposits like the money in your savings account and then lend out that money to business in the form of loans with terms measured in years and decades.  Those long-term loans are then used to fund new investments, like a new factory for a manufacturing company.  These companies are willing to make those investments because the long-term cash flows of the project pay over and above the cost of the short-term investments.

Furthermore, banks take the difference between the long-term interest rate of the loan and the short-term interest rate given to their depositors and book that difference as profits.  It is important for a bank to be profitable because it increases the capital of the bank.  And as the capital of the bank increases, they are able to use that capital to give out more loans.  But there is also a multiplier effect.  Banks have the ability to lend more than their capital reserves based on regulations from the Fed and an international regulatory committee called the “Basel Committee on Banking Supervision.”

Let’s say, for the sake of simplicity, reserves have to be, at a minimum, 10% of assets.  This means that for every $1 of capital, the bank is able to lend out $10 to companies.  Therefore, each additional dollar of capital that accrues to the bank creates $10 of incremental capital available to businesses.

Therefore, yield curves are one of the best barometers of where the economy is going forward.  When the yield curve is “normal,” meaning long-term interest rates (“long end of the curve”) are greater than short-term interest rates (“short end of the curve”), profitable banks lend more and more.  This leads to a virtuous cycle in the economy.  When the yield curve is “inverted,” long-term interest rates are lower than short-term interest rates, banks have no incentive to lend, sending the economy into a death spiral.

As such, if you look at the historic steepness of the American yield curve, you’ll see that it’s been a pretty good leading indicator of recessions (below).  This is why the inversion of the yield curves in Europea is yet another worrying development that is keeping investors up at night.

Source: Federal Reserve H.15 Release

Featured Photo Credit: flickr/AlphaTangoBravo / Adam Baker