over 3 years ago • 4 mins
In its latest annual outlook, investment bank Goldman Sachs flagged a steepening US “yield curve” as one of its key global themes for 2021. There are a number of ways investors can play this theme – but with bank stocks currently trading below the value of the assets on their balance sheets, I think they present a particularly interesting opportunity.
A bank’s basic business model involves borrowing money at low short-term interest rates (think customer deposits and central bank loans) and then lending that money at higher long-term rates (think mortgages, business loans, and so on). A bank’s profit is therefore largely determined by the difference between short-term and long-term rates. The “yield curve”, meanwhile, plots how similar bonds’ yields differ based on how distant their maturity dates fall due. When the curve steepens, the difference between short-term and long-term rates is widening – increasing the bank’s profit.
One of the most common ways to measure the steepness of the yield curve is to look at the difference between 10-year and 2-year US Treasury yields. The graph below shows how this has changed recently, as well as Goldman Sachs' forecast for further steepening.
Why is the yield curve steepening? It’s partly down to the fact that the US Federal Reserve plans to pin short-term rates near zero for some time to come. At the same time, however, increasing market expectations for higher economic growth and inflation in the future are driving longer-term Treasury yields up. Let me elaborate.
The “short end” of the yield curve – the 2-year Treasury yield – largely reflects short-term interest rates. With the Fed now saying it intends to keep short-term rates at rock-bottom levels until the end of 2023, we can expect 2-year Treasury yields to hold similarly steady for at least a couple of years.
The “long end” of the yield curve, meanwhile – the 10-year Treasury yield – is sensitive to inflation expectations. When investors think inflation will rise, longer-term Treasuries do poorly because the fixed amount of cash they regularly pay out to investors would become worth less in that scenario. A $100 “coupon” ten years from now looks less attractive if the cost of food and housing is set to double by then. So rising inflation expectations cause the prices of long-term Treasuries to fall – and their yields to rise accordingly.
And what’s happening to inflation expectations right now? They’re on the rise. Investors have high hopes for both big fiscal stimulus packages and coronavirus vaccines next year; a return to pre-pandemic levels of economic activity would spur demand and drive the prices of goods and services higher. These inflation expectations are being further fueled by the Fed’s new approach to managing inflation. Switching to an “average” target of 2% over time allows the central bank to keep interest rates near zero even when inflation modestly overshoots, given the undershooting of the past couple of years. Put simply, the Fed is willing to tolerate higher inflation in the future.
Taken together, anchored short-term Treasury yields coupled with rising long-term Treasury yields implies a steeper yield curve on debt of all kinds. And as that directly translates into higher bank profits in the future, it should help drive bank stocks higher. What’s more, if investor bets on further steepening begin to gain momentum, bank stocks could get the added benefit of short-sellers closing their positions. Bank stocks have underperformed the US S&P 500 index by 30% so far this year – which has naturally attracted a lot of shorties to the sector.
That underperformance is also one reason why bank stocks are trading quite so cheaply right now: the average price-to-book ratio (P/B) of those included in the equal-weighted KBE exchange-traded fund (ETF) is 0.75x. In other words, you can buy a basket of bank stocks for a full 25% less than the value of the assets on their balance sheets. That P/B is lower than it was in the aftermath of the last financial crisis, despite banks holding bigger capital reserves and therefore being “safer” bets today than they were in 2008.
Of course, Finimizers also need an awareness of the potential risks associated with any investment. The nature of banks’ business makes them particularly sensitive to overall economic conditions. If hopes of a coronavirus vaccine are dashed and the economy heads south again, banks may see more of their borrowers failing to repay loans. And while the rationale for higher longer-term Treasury yields seems solid, we haven’t addressed the elephant in the room: central banks around the world are currently buying up huge numbers of government bonds as part of their “quantitative easing” measures to tackle the economic fallout of the pandemic. If all that bond buying outweighs investor selling in anticipation of higher inflation, we could see long-term Treasury yields fall instead.
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