Value Investing News

I note that the yield curve is finally sloping upward again.  This is interesting because downward sloping curves often precede recessions, yet the curve regained its upward slope right around the time many Economists/ pundits/ would-be experts believe the U.S. is most likely to go into recession.  It will be interesting to see how it plays out.  One thing is of particular note for those of you who have been thinking of buying into the banks: upward sloping yield curves typically mean higher profits for banks, provided that the banks make a significant portion of their revenue from lending (as opposed to investment banking and so forth).  Doing a quick search of rates, banks seem to be borrowing money (via CDs and savings accounts) at around 5% and lending it out at long-term rates of a little over 6%.  That spread is about in line with the bond spreads.  In addition, Uncle Ben at the Federal Reserve seems ready to open the discount window and let banks borrow at lower rates (which he'll likely lower again this month - on the 11th, I believe).

There are two points worth making.  First, even though the bond yield slope is upward, the spread is not very significant (around 1.5%).  On the lending/ borrowing side, banks engage in simple arbitrage by borrowing short term and lending long term, mitigating default risk by lending to a lot of people (at different rates - the 1.5% spread is an off-the-cuff simplification - banks report a blended spread in their annual reports).  The steeper the curve gets, the more money banks will make on this side of the business, assuming they don't fall into the trap of making foolish loans.

Second, regardless of the spread, rates remain low from a historical perspective (as seen from the 30 year here) (of course, the positive spread/ low yield situation can exist with even higher spreads and lower yields, as the Japanese have observed for some time).  Depending on your thoughts about the future of bonds, the situation has various implications.  For instance, it is no longer feasible for most to retire on bond yields.  This is likely to increase future demand for equities, particularly of the dividend-yielding variety.

In any case, the bond market is worth watching for its macroeconomic implications (as suggested in the preceding paragraph), its microeconomic implications (as noted in the paragraph before that), and for its predictive powers (the bond market is amazingly good at predicting whether the Federal Reserve will lower or raise rates, and by how much).