As Fed Funds Cut Looms, Is the Yield Curve Telling Us Something?

Something potentially significant happened last week. And no, we’re not talking about Tom Brady’s career change—it’s the yield curve. 

For over two years, we’ve been hearing that the inverted yield curve—where short-term interest rates exceed long-term ones—was an ominous sign for the economy. Now that the curve is showing signs of normalizing, it seems that’s bad news too, including for some banks. What’s happening here? 

An inverted yield curve normally signals recession risks, but according to TheStreet, “the recession it predicts doesn’t occur until the yield curve normalizes, with short-term yields falling below longer-term yields.” This sequence is exactly what we saw last week, as the yield curve, which was inverted for 783 consecutive days, briefly normalized for the first time since July 2022. 

What this means about the strength of the economy is ambiguous and may actually signal economic turbulence ahead. In fact, a weakening economy, including unemployment ticking up to 4.2%, is part of the calculus driving the Fed’s widely expected interest rate cuts. With both inflation easing and labor market data softening, some experts predict that the Fed could cut rates by as many as 50 basis points at its September 18 meeting. Others say the Fed has already waited too long to stave off a recession.  

For banks, these developments signal potential challenges ahead. All banks will be affected by the economic uncertainty, with the possibility of increased credit risk and weakened loan demand that would accompany a recession. As for the rate cuts, while they will allow banks to reduce the interest they pay on deposits, they may also reduce what banks earn on certain loans and investments. How an institution’s profitability is affected will depend on the shape of the yield curve and the bank’s size and mix of assets and liabilities. 

Big banks: Large, universal institutions are expected to face more pressure from rate cuts because, as this explanatory Seeking Alpha piece notes, they “are broadly asset-sensitive to the short end of the Treasury yield curve.” As a result, their earnings from these assets can decrease more sharply when rates drop.  

At the same time, they stand to lose a bit of an advantage on the liability side as rates recede. Large banks have benefited from higher rates more than their smaller counterparts, in part because they’ve been able to keep deposit rates relatively low. In fact, the Financial Times and Bloomberg noted in the spring that a delay in expected Fed funds rate cuts would help bottom lines at these banks beat expectations. But now, a decrease in the Fed funds rate threatens to chip away at that income-boosting arrangement.   

JPMorgan Chase has already signaled concerns about the effects of these rate cuts. According to JPMorgan President Daniel Pinto, analysts have been overly optimistic in projecting next year’s net interest income (NII), with current estimates of $89.5 billion being “not very reasonable” given the expected rate environment. Pinto stated at a recent industry conference that the bank’s NII “will be lower.”  

Regional banks: In contrast, regional banks, with their comparative focus on fixed-rate home, small business, and personal loans, are more exposed to the longer end of the curve and may not feel the same immediate hit to earnings when short-term rates are cut. 

However, they could still face pressures on deposit costs, as customers may see their interest rates fall and seek higher yields elsewhere, forcing the banks to raise deposit rates to remain competitive. While rate cuts can help banks by reducing their funding costs, the pressure to retain deposits may offset some of those benefits. Some analysts, like HSBC’s Saul Martinez, suggest regional banks could see an improvement in NII later in 2024 as deposit costs stabilize and loan growth picks up.