Tuesday, August 09, 2005

What a Flat Yield Curve Does

Today’s Wall Street Journal has an article about what could happen if the yield curve goes flat. In short, banks lose the incentive to lend, which means that it will be harder, or more expensive to get a mortgage.


“A flattening yield curve removes banks' age-old profit model: Borrow money at low short-term rates and lend it out to people and companies at higher long-term rates. Already, as rates converge, banks are cutting costs to address their shrinking profit margins. "Banks are scrambling, because they have this huge amount of income that is disappearing that they need to replace," says William S. Demchak, chief financial officer of PNC Financial Services Group Inc.

Should the curve end up "inverting" -- with short rates climbing above long -- banks could lose their incentive to lend. That is one reason previous flat yield-curve inversions have signaled recessions, though some economists think this time will be different. Now, they say, falling long-term rates have offset the braking effect of the Fed's short-term rate increases, in what traders call a "bull flattening": People and companies are able to bypass banks and secure low, long-term rates from other lenders or even through the bond market, meaning they still are able to make big-ticket purchases, including that new home or factory.”


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