Treasury yield curve and short-term wholesale funding markets’ risks
The Treasury yield curve graphically represents interest rates for various Treasury (TLT) (TBT) maturities. The difference between 30-year and five-year Treasury yields is called the slope of the yield curve. When the difference narrows, the yield curve flattens. When the spread widens, the yield curve gets steeper. Borrowing in the short-term wholesale funding market while investing in longer-term assets, allows financial intermediaries (XLF) (KBE) (KRE) to earn returns. However, undertaking short-term funding has risks.
Historically, a flatter yield curve had an adverse impact on the financial institutions’ returns. It lowered their net interest margins. The Fed continues to stress an accommodative monetary policy. The policy and strong overseas demand have kept yields low at the long end of the curve. As a result, the difference between 30-year and five-year Treasury yields fell to 154 basis points on September 5, 2014. The yields were 235 basis points on January 2, 2014.
In his testimony to the Senate Committee on Banking, Housing, and Urban Affairs, Fed Governor Daniel Tarullo said that a flatter yield curve reduced wholesale funding volumes. He also said that the situation may not continue in the future.
A steepening yield curve impacts financials sector firms’ returns
As the economy improves and the Fed starts monetary tightening, markets will begin pricing in higher future inflation expectations. This will increase yields at the long end of the curve. As a result, the yield curve is likely get steeper. This would be an incentive for financial intermediaries to borrow in the short-term wholesale funding market. Investors would use the funds for longer-term investments. This would increase volumes in the short-term wholesale funding market. It could lead to higher risks.
In the next part of the series, we’ll discuss the Fed’s initiatives to mitigate risks in the short-term wholesale funding market.