SVB’s collapse shows the yield curve is always right
- By Nicholas Jasinski,
- – 03/14/2023
Financial markets’ favorite negative signal, a so-called inverted yield curve, has been flashing red since July, and its record of predicting bad news remains intact.
In ordinary times, investors tend to demand higher interest to lend for longer periods because there is more inflation and interest-rate uncertainty over the long term than in the short term. When short-term U.S. Treasury yields exceed longer-term yields, it is a sign that investors expect higher interest rates or economic risk in the near term, and demand more compensation.
That condition, called an inverted yield curve, has preceded the past eight U.S. recessions. At its core, the Silicon Valley Bank drama is all about the yield curve, or the slope plotting interest rates on Treasuries of different maturities.
The difference between the yield on the 6-month Treasury bill and the 10-year Treasury note hit a record 1.33 percentage points last week. The Federal Reserve has increased interest rates at an unprecedented pace over the past year, but that’s not all good news for lenders like banks.
The bread-and-butter business of a bank like SVB (
Savings, checking, and business accounts are short-term liabilities—they can generally be withdrawn on demand at any time. A bank’s assets are the loans it issues or its Treasuries and bondholdings, which tend to be long-term, measured in years or decades. Think of a typical thirty-year mortgage funded by customer deposits.
Banks are essentially borrowing short in order to lend long in a form of a carry trade. When shorter-term interest rates and bond yields exceed those on longer-term loans and bonds, that model falls apart.
So far, banks have dealt with the inverted yield curve by dragging their feet on raising the interest rates they offer. Try to find a checking account paying anywhere near the 4.75% fed-funds rate today. Meanwhile, banks have been charging higher interest on their loans, helping to keep net interest margins positive despite the inverted yield curve.
That can’t last forever. Customers have increasingly been voting with their feet and seeking higher income elsewhere.
“That has changed more recently with depositors deciding to pull their money from traditional banks and putting it into higher yielding securities like money markets, T-Bills, and the like,” writes Morgan Stanley’s Mike Wilson. “We expect that trend to continue unless banks decide to raise the rate they pay depositors. That means lower profits and likely lower loan supply.”
That dynamic alone isn’t what directly caused SVB to collapse, but it created an environment that made the bank much more sensitive to a run as its cash flow was squeezed. The speed of the rise in interest rates and inversion of the yield curve over the past year added to the pressure, pushing the bank to sell assets at a loss to meet demand for withdrawals.
The inverted yield curve was the catalyst for the series of events that led the particularly sensitive SVB to implode.
“Something always, always breaks when the Fed hikes, and with a deeply inverted curve now, the carry trade came unstuck once there was more demand from depositors to withdraw their cash for 3 reasons,” writes Deutsche Bank’s Jim Reid. “1) cash burn of tech companies, 2) higher deposit rates elsewhere as rates rose, and 3) the final fears, after the huge security sale mid-week, that the bank was in trouble. So ultimately we saw an irreversible bank run.”
The SVB episode is a result of the Fed’s tightening campaign. Banks are finding it tougher to make profitable loans with today’s inverted yield curve, and that slows the expansion of the money supply—working against inflation. Monetary policy famously works with “long and variable lags.”
SVB’s failure is a sign that it has caught up.