The Squeeze is On

To almost everyone’s surprise, the 10-year U.S. Treasury bond is selling below a 4.5% return. Based on historical data, the 10-year Treasury should be selling at well above that level as the economy gains strength, unemployment declines, and corporations start spending for capital goods.

At the same time, the Federal Reserve continues to raise short-term rates (the only rates it can control). As I write this, the rate is 3.5%. This combination results in a flattening yield curve, which means the squeeze on interest margins for financial institutions is getting much worse. As we all know, the health of the banking industry essentially depends on a spread between long- and short-term rates for interest margin profits.

The current situation makes life difficult for banks, particularly so for community banks, which have traditionally earned most of their income on interest spread. While they are also subjected to the “squeeze,” large banks have generally had a larger percentage of their income (about 50%) from fees, which provide income outside the interest rate environment.

The current situation confirms the desirability of fee income as an increasing part of a bank’s’ earnings. But, for most community banks, noninterest income is still a small part of their profits and can’t be increased quickly.

The current squeeze conditions are unprecedented; therefore, community bankers will have to be creative to keep profits up and shareholders happy. They must try to predict how long these unusually low long-term treasury rates will continue and, also, how long the Fed will continue to increase short-term rates. On this subject even my usually reliable crystal ball clouds when I peer into it.

Assuming a continuation of a flat (or flatter) yield curve, what’s a community bank to do? What are some of them already doing?

First, they are taking advantage of the fact that low, long-term rates have helped fund a housing boom. Mortgages made and sold can provide fee income that is essentially like fee income.

Second, banks can move aggressively into noninterest income activities, particularly insurance sales and money management.

Third, they can use their judgment to evaluate how long these unusual long-term rates will continue and position their balance sheets accordingly. (The long-term rate phenomenon has been explained in many waysu00e2u20ac”large foreign central banks purchases of U.S. Treasuries as the result of dollars accumulated from trade surplus; change in investor behavior due to the look of a visible inflation threat, etc.)

Finally, they can remind the Fed that increasing short-term rates too swiftly and aggressively can lead to real problems in the banking. Remember what happened when the former Federal Reserve Board Chairman Paul Volcker increased rates to the level that helped push almost 1,000 banks and S&Ls to fail? It wasn’t pretty.

The new Fed chairman will be facing some tough calls. But, being chairman of the Fed has never been an easy job. Let’s hope we get someone as good (and as lucky) as the present chairman.