One Reason To Actually Worry About A Flat Yield Curve

From the Wall Street Journal (page C1 of the print edition):

For almost a year, the flat Treasury yield curve loomed on the horizon.

Bankers could see it coming. They had time to plan, knowing that the narrowing spread between short- and long-term interest rates squeezes their profits.

But the flattening yield curve has stymied even some of the most sophisticated and well-equipped banks in the U.S.

The nation's three biggest banks-- Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. -- were expected by many analysts to move past the flat yield curve in 2005 and beyond without sustaining significant damage to their bottom lines.

But all three -- like many smaller brethren in the financial-services industry -- posted disappointing results for the fourth quarter, and investors punished their share prices. Each cited the flat yield curve as a contributing factor, an obstacle many bankers and bond traders see in place until at least midyear...

The difference between the shorter- and longer-term rates affects not only a bank's core business of collecting deposits with a relatively low rate paid to customers and lending out that money at a higher rate. The net profit that banks, especially the bigger ones, can make from their credit-card operations and their currency, securities and other financial trading also is affected.

Banks unable to raise all the money they need to lend or conduct trades must borrow money on a short-term basis. They attempt to make more money by lending it out at a higher rate or investing it in better-yielding longer-term securities. But with the long-term and short-term interest rates about the same, that is a much less-profitable exercise.

Our friend Brad Setser says it well:

"There is a very flat yield curve globally for different reasons, even in some emerging markets," said Brad Setser, head of global research for the Roubini Global Economics Monitor, a New York-based economics Web site. "I really don't see where the easy money is. No matter how sophisticated you are, you can't get away from the basics of banking: Borrow short, lend long," he said.

If you are an optimist, this is for you:

... analysts are cautiously optimistic about 2006 when it comes to the yield curve's impact on the big banks' performance. "The bulk of the damage has been done," said [Jeff Harte, a Chicago-based banking analyst at Sandler O'Neill]. "The question is when does it get better?"

Sounds like the reaction to the last GDP report.