The Yield Curve Conundrum

What to do about the inverted yield curve? In this episode of the Purposeful Banker, Dallas Wells explains how bankers should adjust to this tricky environment and how their banks can help them make sound long-term decisions about each customer and each deal.


Helpful Links

Economic Forecasts With the Yield Curve (Federal Reserve Bank of San Francisco)

How Does an Inverted Yield Curve Affect Your Business Strategy? (FNBO)

Bank Strategy for the Next Recession (Purposeful Banker) 

ALCO Q&A With Darnell Canada (PrecisionLender)


Maria Abbe: Hi, and welcome to The Purposeful Banker, the podcast brought to you by PrecisionLender where we discuss the big topics on the minds of today's best bankers. I'm Maria Abbe, senior communications manager here at PrecisionLender. And today's show features Dallas Wells, who is our EVP of strategic initiatives at PrecisionLender, and Jim Young, our director of content. They're talking about the inverted yield curve and they're discussing how bankers should try to adjust to this tricky environment and also how their banks can help them make sound, long-term decisions about each customer and each deal. We'll have links in the episode notes to relevant articles and information. Now, onto the show. Enjoy.
Jim Young: Dallas, let's start off with basically our client success team is out there on the phone with bankers every day. It's great way for us to get a sense of kind of what's going on out there. Can you share with our listeners what really the hottest topic has been in those conversations lately?
Dallas Wells: Yeah. Usually these conversations are all over the place, and you've got banks talking about lots of different things depending on what's going on with them in particular and their market and their strategy. That's not the case today. The majority of questions and conversations are, "What the heck do we do with rates getting as low as they've gotten?" And probably the more difficult part of it, "Hey, this curve is inverted. What do we do with that?" So lots of conversations about that. Some of them very technical and wonky.` Some of them feel more like therapy sessions where it's just like, "Hey, we're all in this together. We'll figure it out." But that's definitely been top of mind for everyone.
Jim Young: So how ominous is an inverted yield curve? I mean sometimes it seems like it's the last sign before Armageddon. But then other times people say, "Hey, you know, this happened months ago and here we are, we're still chugging along."
Dallas Wells: Yeah, I think it's one of those indicators that you'll tend to be at two ends of the spectrum. On one end of the spectrum is, "Hey, it's the best indicator we have. And when this happens, it's a problem." At the other end it's like, "Yeah, but this has predicted eight of the last five recessions," right? So it's not all that accurate, and sometimes this just happens. And it's true that there are occasional inversions within the curve, right? It rarely stays a consistent kind of perfect upward sloping curve. There's anomalies within there, but this is not that, right? This is not a strange little blip at some point in the curve. This is a full-on inversion, if you look at the treasury curve, from the three month for awhile all the way out to the 30 year point in the curve. So the entire thing is pointing the wrong direction.
So does it predict a recession? I don't know about that. And I don't know that the banks necessarily really care right now. They're more dealing with the first sets of issues, which are, "Hey, three-month rates are higher than 30-year rates. What the heck? Our entire business model kind of requires it to be the other way."
No matter what your ALCO committee and your interest rate risk models might ask of you, the fundamentals of banking are take in money short and you invest it long, and you collect the spread in the middle. That's the lowest form of risk that a bank can take and just kind of make easy money day after day, year after year. So when that goes away, it causes some real issues. And so is it ominous in terms of what it's predicting? I don't know. Is it ominous for how banks make money? Yes, absolutely, without a doubt. That part is just fact.
Jim Young: And you've mentioned this I think in some previous podcasts, a little bit of a chuckle about some bankers will kind of almost want to game that yield curve like, "What do I do to make that curve go the right direction?" And I'm kind of curious what this says about bank operations, that bankers are basically in those situations trying to alter reality rather than adjusting to it. Or could you argue that the yield curve maybe isn't actually, well, reality? Was that too deep?
Dallas Wells: Yeah. Gosh, you took me aback a little bit. I feel like we should be sitting around a hookah to have this level of depth of the conversation. But I think that's what banks have to figure out, right, is how real is this for them? And so what we hear from some of the community banks, and they're not wrong with this assertion, is they're like, "Look, in our market when we're putting together deals, the curve is not inverted." Basically, we're all kind of, I don't want to make it sound like collusion, but we're not going to price five-year deals cheaper than two-year deals. We're just not doing that. So if I'm not directly competing against someone that's doing it, it's not my reality." And our argument is, "Well that's not really true because part of what you have to do to measure the risk in those sorts of structures is you have to assume a funding costs, right?"
So you don't just use the bank's average cost of funds to figure out how profitable those potential deals are. Instead you have to look at what would the marginal funding cost of that be. And for most community banks that are making that argument, it's a really simple exercise. You pick up the phone and you call the federal home loan bank and you say, "What's the rate on a two-year fixed rate advance and what's the rate on a five-year fixed rate advance?" And you can even match fund those things with amortizing advances. So you can find out exactly what your marginal funding costs would be for that exact structure that's in front of you. And those curves are inverted. So it may be true that you're not competing against that for those transactions, but the reality of the risk that you're taking on and the risk-adjusted profitability of those transactions is that that curve is inverted.
And so good for you, right? You get to fund it cheaper out at the five-year spot in the curve and no one's forcing you to make the deal at that lower rate because that's not the reality in your marketplace. But it's the reality for your funding, it's the reality for your securities portfolio. So as you're making decisions about trade-offs between, "Do we loan this money out? Do we invest in the bond portfolio?," those are fairly simple trade-off analyses that you can do in a community bank. And that curve inversion is a part of your balance sheet. So you can't just pretend like it's not.
So a couple of things with that. When you say, 'Is it not reality?," I think that it is. And where banks get in trouble is when they try to pretend like it's not. And so they try to put their thumb on the scale and ... The question they ask of us is, "Well, can you just make adjustments to that funding curve that we're using to figure out how much it costs us to fund this so that it has the proper slope?" And people will say, "So that it's right." And I'm like, "Well, the right curve right now is inverted," right? Like, "I know it looks funny, but that's right." So what they say is, "I want it to feel normal," right?, "like it typically does. I want it to be upward sloping because that's comfortable. That's how I make money."
And I think all that's doing is distorting your own reality and causing you to make uninformed decisions, right? It's basically you sticking your head in the sand and saying, "This isn't happening, la, la, la. I just want to book deals where it's comfortable because that's what it looks like."
Now, you may still decide again to keep the way you price deals out in the marketplace with a normal upward sloping curve, but you just need to understand what that's doing. That's communicating to the marketplace what your preferences are. So if the market at large has an inverted curve and you keep yours with a normal shape, what you're saying is, "Everyone else right now prefers to lock in rates at longer and longer terms. That's where they feel safety. I actually prefer shorter-term deals. I would rather move down in duration. I don't want to do five-year deals. I would rather do one-year or floating-rate deals," because that's how you've priced relative to the rest of the market. And the reason that often tends to be a bad idea in these sorts of situations is an inverted yield curve is the market predicting that rates go down from here. And you just decided that you want to incent your customers to take shorter and shorter deals so that your portfolio reprices faster and faster as rates go down. And this happens, this is the reality.
This is what happened during the last inversion, which happened in 2006. A lot of banks did this. They shortened the heck out of their portfolios, and then the unthinkable happened and fed funds rate went to zero. And their portfolios not only were getting hammered from the credit side, but priced down to almost nothing in terms of nominal yields. And they couldn't get their cost of funds down fast enough. And so they were getting squeezed from all directions, and some of them didn't survive. So these are real risks that can have real consequences. So what the bank has to do is I think measure it in reality, measure what that deal, what that relationship really looks like, and then you can decide what your appetite is along that curve, along that duration spectrum. And you can decide where you want to book business, but do it with your eyes wide open. Don't fool yourself into making it look the way that it should. I'm doing air quotes on a podcast, but the way that it should because that's comfortable. Instead, do what's based in reality.
Jim Young: All right. I'm going to ask the naive, non-banker question that's going to get you to say, "Oh Jim," and pat me condescendingly on the head after I ask it, but we're talking about, "Hey, this is what happened with the inverted yield curve last time and this is what people do." So this isn't like a once every 500 year storm where everybody goes, "What was that?" I mean I guess my question is, is why don't banks sort of have, "Hey, when this happens, which it will at some point, this is what we do," rather than, "Oh, it's happening. Can you make this not happen?"
Dallas Wells: Yeah, I think people always hope that it's a really short, temporary thing, and so they just try to fudge it for a little while. And that week ends up being a quarter and ends up being six months, and all of a sudden they've turned over a third of their portfolio into those sorts of structures that they incented. So I think it's just that people don't have a plan for this. They just react to things as they happen. They don't have a formal strategy.
And so I mentioned ALCO earlier, and I think that's where a lot of banks miss the opportunity with ALCO. They view ALCO as a backwards-looking, we run reports, we measure the interest rate risk, we kind of see what happened, and after we booked everything we say, "Well how much risk landed on the balance sheet and are we still within policy?" Vast majority of the time, "Yep, we're still within policy." So everybody gives it a thumbs-up around the table and we meet again in three months, or whatever your process is.
That's not how ALCO should work. ALCO should be about exactly this. It should be about coming up with strategies for this. You should be talking about, "Hey, the curve is really flat." Right? This didn't sneak up on us. The curve got flatter and flatter as the fed increased those short-term rates. And basically, they just raised the short end all the way up until it went above the belly of the curve. And then a lot of macro global things happened that pushed that long end of the curve way down, and you've got the fed sort of artificially holding up the short end. And so this has been visibly coming for a long time, months and months and months. You should have talked about at the management level, at the board level, at the relationship manager level, "This is what rates are doing and this is our reaction to it." By the time things look like this, it shouldn't be time to scramble and figure it out because it's going to be too late.
And I think the other thing is something that Carl mentioned in the conversation he had with David Brear on a podcast a few episodes ago. These things happen in cycles and there's a natural rhythm to those, and it's because people forget. So we're talking about I mentioned the last one was in 2006. This is 2019. There's a whole lot of bankers who either weren't around for that or there's been a good, solid decade and a half almost of things just chugging along, kind of as normal, nice, quiet. We're into a decade of quiet credit environment. And interest rates have been low but pretty normal otherwise. Right? The yield curve itself has been... In fact, it was really steep for a while.
So it was a really healthy way for banks to make that borrow short, lend long spread. And that's why you saw margins really recover pretty well. There was lots of room there to make money in between. And now that that's gone away, they're like, "Golly, I don't remember what we're supposed to do here." And the last time it was like this, the world was different. So how do we react now? So that's why these things happen in cycles, is people's memories are short and eventually the same problems come back around again.
Jim Young: Well, all right, before we get too depressed about that, it's easy for us to sit here from the cheap seats and sort of take shots at what banks are doing wrong or what they haven't done so far, and that sort of thing. So let's put you in sort of the hot seat. You're running commercial sales strategy at a bank. You haven't, to this point, sort of reacted to, done the stuff that we said you probably should have done. What do you tell your bankers to do now? And I guess, more importantly, how do you get them to do it? Because it's one thing to say this is what we should be doing. But as you mentioned, when you're in that deal with that person, that the temptation maybe to try to do something else might be pretty strong.
Dallas Wells: Yeah. So this is where, and we hear this a lot especially from, again, community banks, and there's a lot of truth to it, but they say, "Our bankers just know how to put deals together. They have a good pulse on where the market is and they know what the market will bear. And so we just trust them to go put these things together." And that's true. But what you have then is a collection of bankers all out in the marketplace and things like an inverted yield curve happen, and nobody reacts to it first. Right?
And so I think the, "How do you get them to do things?," I think you actually have to start there. That was the end part of your question. But I think you have to start there. You have to have a clear way of communicating what expectations are and, if nothing else, "Here's the range within which you can operate." And make that clear for your bankers, what the expectations are. And that should be a pretty dynamic process, right? You should have a way of communicating that out realistically every day. But if not, then every week, once a month, right? There should be some regular pattern where, "This is where you can operate," if you don't have a sophisticated platform to help inform that process.
And the other part is... And a lot of what we end up doing is sort of flipping this question around on banks. They say, "Look, there is no way that I'm willing to do five-year deals at the rates that are being spit out of what the math says, right? Like there's just no way. I don't want to do that. The rates are too low." So we just turn that around and say, "So you believe rates are abnormally incredibly low and it's basically a screaming bargain for your borrowers at the five-year part of the curve?" "Yeah. That's what we think." "Okay, then that's a strategy, right? Take market share, right? Find the place where you're able to make something happen that your competitors won't, or at least will have to follow along. And if five-year money is dirt cheap, go load the boat on borrowings at that level."
Now, by the way, I would not actually recommend doing that. Speculating on rates is always a terrible idea. But if you're that strongly convicted about that this is an abnormally low thing, it's a temporary, strange situation, take advantage of it. Put your money where your mouth is if you really believe that. Otherwise, follow what the yield curve is. Your job is to earn a spread, not to dictate interest rate term structure to the multi-trillion dollar rate market at large. You can't fix it. It is the reality. So instead, learn to operate within that reality. Remove the interest rate risk from it, if that's what you're scared of. There's lots of ways to do that. You can do that.
I talked about the simple way, call up the federal home loan bank, the accounting process for doing back-to-back loan interest rate swaps. So you can hedge it with derivatives in a pretty simple clean way. And there's lots of partners out there, Chatham, Derivative Path, some of the larger banks like PNC and Wells Fargo, that are really good at helping community banks get that stuff done. So there are ways to take advantage of this and to turn it into a benefit to you to gain some market share that are all based in reality and you can do pretty safely. And in fact, I think that's safer than just pretending like it's not the case and, because no one else in your market as blinked yet, you'll just keep it where it is. Move fast, right? Take advantage of those things. And if nobody else is willing to go out there and steal some of the best customers in your market with solidly priced, fairly priced, five and 10-year structures, there's your opportunity.
Jim Young: Yeah, that makes sense. But I got to mention, it's also a little bit scary when you look at it and go, "I think this is an opportunity," and you sort of say to yourself, "Well, why isn't anyone else doing this?"
Dallas Wells: Yeah. And that's why bankers sometimes tend to over-focus on spread. But in this case, it's the right metric. Who cares what the nominal rate is, right? You don't live off the nominal rate, you live off the spread. So figure out what that credit spread is. I want to get compensated for the credit risk. When I make a loan, I want to get compensated for the credit risk that I'm taking on. You can actually largely neutralize the interest rate risk. I mean that's kind of banking fundamentals, right?, is isolate the risks that you're taking, make sure you get fairly compensated for it. And what a lot of banks end up doing in reality is they sort of cross the streams, which we've been warned about in Ghostbusters not to do that. They do it all the time anyway.
And so they know what their overall spread is but they don't do a good job of isolating, "Well, how much of that is for the interest rate risk that I'm taking on and how much is for the credit risk that I'm taking on?" So get more disciplined about isolating those two things. Get paid for whichever one you're taking, properly. And so if the interest rate risk is what's scaring the pants off of you in this situation, which is what you're saying when, "Hey, this feels scary," isolate that risk, minimize it.
You can sort of remove some of that spreads, say, "Hey, I don't want to take that risk." You can remove it. Your overall spread will go down but you'll still be getting compensated for the credit risks that you are willing to take. So you just need to find good ways of, in a transparent way, figuring out what those are, making decisions about them, and then again communicating that out to the people that are actually negotiating with your bankers. That's what we do all day, every day. That's what we built PrecisionLender to do. But even in a really small community bank, those are the fundamentals. And how you actually deliver that information, you can be flexible with, but that's the stuff that has to get in your banker's hands.
Jim Young: Yeah, I was just going to say when you were talking about the isolating the credit risk and the interest rate risk, and all that sort of thing, I was thinking to myself, "Okay, this is stuff that I know the guys, that we'll usually call back-of-the-bank guys, probably can eat for dinner." But trying to get that to the guy who actually out there trying to structure a deal... Because he doesn't need to be crunching through numbers. He needs to have that information telling him, "Here's what you're looking at and here's what you can do."
Thanks a lot, Dallas. Glad we got another tricky banking issue resolved in just about a 30-minute podcast.
Dallas Wells: Yeah, problem solved. Yep.
Jim Young: Yeah, problem solved. No, but I do think it's a matter of really being thoughtful, like a lot of that stuff, thoughtful in your approach on it.
Maria Abbe: And that'll do it for this week's show. Now, for a few friendly reminders. If you want to listen to more podcasts or check out more of our content, you can visit our resource page at Or you can just head over to our home page to learn more about the company behind this content. Finally, if you like what you've been hearing, make sure to subscribe to the feed in iTunes, Google Play, or Stitcher, and we would love to get ratings and feedback on any of those platforms. Until next time, this is Maria Abbe for Jim Young and Dallas Wells, and you've been listening to The Purposeful Banker.

About the Author

Jim Young

Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer. Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships. Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.

Follow on Linkedin More Content by Jim Young
Previous Article
What's in a (Bank) Name?
What's in a (Bank) Name?

How much do bank names matter? What prompts them to sometimes make a name change? And why are so many bank ...

Next Article
The Story of Beal Bank: Why It Still Resonates
The Story of Beal Bank: Why It Still Resonates

In this episode, we discuss Beal Bank, an unusual bank with an interesting story. It's one that should reso...