The Government, Banks and the Importance of the Yield Curve

What's this all about

A Yield Curve is generally a chart showing the relationship between the Interest Rate and the Time to Maturity of a Bond. It is widely used by Fixed Income investors and economists as an economic prediction tool. This week’s Thought provides background to support the theory that the end of Quantitative Easing may not be as bad as many think. Those forecasting the end of economic recovery once the Government shuts off the monetary faucets may be premature. Quantitative Easing has really been about supporting the banking system, not creating jobs and stimulating the general economy.

The Yield Curve

The current yield curve for U.S. Government Treasuries is shown below: the longer the maturity, the more yield (or interest) an investor requires as compensation for the longer holding period and the additional risk this may entail.  As an example of how this helps economists, a steeper curve as you move to the right usually signifies a higher probability of future interest rate rises.

                                     

The Treasury Yield Curve is also an indication of future interest rate policy in that it shows the ‘risk-free’ investment return available by buying a Bond which is backed by the U.S. Government.

  

Anyone buying or selling debt has to compete with this curve. For example, if the U.S. Government will pay you 3.6% a year to loan it money, why would you consider an income investment yielding any less? You wouldn’t, you would ask for a higher return to compensate you for the higher risk. 

The higher the implied risk, the larger the yield “spread” between the competing investment and the U.S. Treasury of the same maturity. Corporate Bonds, which carry the risk of corporate failure and default on interest payments, have similar shaped yield curves but feature higher interest rates. 

One important feature of the current yield curve is the “near-zero” short term level. If you loan money to the U.S. Government for between one and three months, they will pay you virtually zero interest. The interest rate only goes above 1% for loans of three years or more. Normally, short term interest rates are 2% to 3%. 

Banks and the Treasury Yield Curve 

Banks generally borrow at the short end of the yield curve and lend at the long end. Therefore, their profit margin depends on the difference or spread between long term and short term interest rates.  

For example, if a bank issues a 30-year mortgage at 6.6% (the 30-year Treasury plus 2%) and borrows the money from the Government at 1.3% over 3 years, they make a 5.3% margin in return for managing the difference in loan maturities and the difference in risk between lending money to a home owner and borrowing from the U.S. Government.

Note: Pretty much all loans are related to the Yield Curve because all lenders have to compete with the risk-free rate of return offered by the U.S. Government.

Federal Funds Rate (FFR)  

In reality, banks borrow money from other banks at the Federal Funds Rate (FFR) which is controlled, but not set, by the Federal Reserve.  The Fed influences the FFR by controlling the supply and demand for Treasuries.  Bottom Line: The Federal Reserve is lending money to banks, through Quantitative Easing, at near zero short term rates.  

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