Bank equity performance and the yield curve

  • By Chamath De Silvia

Betashares’ Chamath De Silvia assesses the outlook for bank shares amid regulatory changes and record near-time record low yields. 

Global banks are increasingly moving back towards traditional banking and scaling back functions like wealth management and trading due to regulatory initiatives like Dodd-Frank in the US and the Royal Commission in Australia. 

As a result, when viewing the prospects for bank shares, it’s important to assess the merits of the banking model, particularly with yields at or near all-time lows across the developed world.    

At a very high level, banking is fundamentally a carry trade – borrowing short-term and lending long-term, with the net interest margin reflecting both a liquidity and a credit premium. 

A key determinant of the profitability of this trade is the yield curve – how rates evolve with different maturities. 

Steeper yield curves typically result in more profitable banks, while flatter curves undermine profitability. Although there are many measures of the yield curve, we will focus on the spread between the 5-year swap rate (a rough proxy for lending rates) and the 3-month interbank rate (a benchmark rate for wholesale funding). 

A flat curve can incentivise corporate borrowers to lock in relatively low long-term rates by accessing capital markets directly through bond issuance, bypassing the main commercial lenders altogether. In addition, flatter curves can incentivise yield-seeking non-bank credit investors to enter the market (increasing competition for loans and driving down margins) or induce more borrowers to refinance into fixed rate mortgages. 

Historical relationship between the yield curve and relative performance of bank equities

Using the 5-year/3-month swap spread and the relative performance of the applicable banking subsector against the broader index on a total return basis, we can see banks tend to outperform as the curve steepens and underperform when it flattens.   

For the US, this relationship broke down somewhat in the lead up to the 2008 crisis, where banks were increasingly reliant on investment banking, proprietary trading and securitisation during the height of the credit bubble. Post-crisis, we’ve seen a much clearer relationship between the curve and relative performance of US banks against the broader S&P 500 as traditional banking functions have become prioritised. 

Across the Atlantic, Eurozone banks have struggled since 2008 against the broader EuroStoxx index, with the European debt crisis compounding the problems arising from the GFC. 

Australian banks have fared better than global peers post-crisis, although relative performance in recent years has been curbed by the introduction of various policy measures, including macro-prudential restraints on loan growth, a bank levy and the Royal Commission. 

Furthermore, a slowing domestic economy and uncertain outlook has raised the likelihood the RBA will cut the Cash Rate, potentially presenting further headwinds for profitability if steepening pressures do not emerge.

Chart 1: S&P 500 Banks (GICS subsector) against S&P 500 Index, total returns. 3-month USD LIBOR used for 3-month interbank rate.  


 
Sources: Bloomberg; Betashares Capital.

Chart 2: Eurozone banks against EuroStoxx Index, total returns. 3-month US LIBOR used for 3-month interbank rate. 


 

Sources: Bloomberg; Betashares Capital.

Chart 3: S&P/ASX 200 Bank Sub-index against Nasdaq Australia Completion Cap Index (ex-top 20), total returns. 3-month BBSW used for 3-month interbank rate. 


 
Past performance is not indicative of future results.

Sources: Bloomberg; Betashares Capital.

Monetary policy near the lower bound

In the past, central banks would reduce short-term interest rates to ease financial conditions and attempt to stimulate the economy. 

If the actions were credible, longer term “reflation” expectations would form as the market began to price increased economic growth in later years and eventual rate normalisation, driving a steepening in the yield curve and improving banking sector profitability. 

Such a move is known as a “bull steepening”, where yields across most maturities tend to fall, but to a greater degree at the short end of the curve. 

However, if nominal rates are already very low, as is currently the case in Australia, central banks may not be able to ease financial conditions sufficiently before hitting negative rates. 

In such circumstances, the use of forward guidance – commitments to keep policy accommodative – or outright asset purchases (“QE”) may help ease financial conditions. 

However, unlike conventional measures, these unconventional measures tend to exert a flattening pressure on the yield curve and, at worst, potentially entrench disinflationary expectations, particularly if there is a large build-up of private sector debt. 

This is something the Australian bond market is already seeing, evidenced by a relatively parallel shift lower in the curve rather than the “bull steepening” we’ve come to expect from past easing cycles. 

The chart below shows the expected 6-month cash rate change (proxied by the forward 6-month OIS vs the current cash rate) and the 12-month forward spread between the 5-year swap rate and the 3-month interbank rate. 

There are two clear messages: 1) the RBA is expected to cut the cash rate below 1.00%; and 2) these expected rate cuts, on their own, are not anticipated to be enough to drive inflation materially higher or produce a steeper yield curve. 

Although the first-order effects of lower cash rates may be a drive towards higher-yielding credit and dividend-paying stocks as investors seek income, we should assess the longer-term impact on interest margins and bank profitability. At the end of the day, it’s total return that matters.  

Chart 4: 6-month expected cash rate change and 1-year expected curve slope. Sources: Bloomberg; Betashares Capital

 


Chamath De Silvia is a Chartered Financial Accountant and Portfolio Manager with Betashares