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Flattening yield curve squeezes banks
As the Federal Reserve tries to temper inflation, banks feel pressure from narrowing rate gap.
August 9, 2005: 10:17 AM EDT
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NEW YORK (CNN/Money) - The Federal Reserve's moves to keep inflation under control has put pressure on banks and Wall Street firms as the yield curve flattens, according to a report in The Wall Street Journal.

A flattening yield curve -- the difference between short- and long-term rates -- is generally an issue of concern for banks that borrow money at low short-term rates and lend it to consumers and corporations at higher long-term rates. As the spread between long- and short-term rates fall, banks are struggling to replace the loss of income. If market watchers' predictions prove accurate, the yield curve could disappear by the end of the year.

The Fed is expected to raise rates for the tenth time in 14 months, bringing the short-term interest rate to 3.5%. But long-term rates are still dramatically low, and according to a poll by the Bond Market Association, 12 big Wall Street banks and securities dealers forecast that the spread between long- and short-term rates could fall to 0.15 percent by then end of 2005.

As of yesterday, the spread fell to about 0.27 percent.

And if short-term rates start to climb higher than long-term rates, banks could lose their incentive to lend. In the past, a flat yield curve inversion has signaled the start of a recession, but some economists see a different scenario this time around. Economists speculate that falling long-term increases have offset the braking effect of the short-term rate increases, which could allow people and companies to bypass banks altogether and obtain low, long-term rates from alternate lenders or the bond market.

That's good news for consumers and bad news for the banking industry.

The flattening yield curve has already taken a toll on second-quarter earnings at large players such as Bank of America (Research), North Fork Bancorp (Research) and J.P Morgan Chase (Research), according to an analysis by Piper Jaffray & Co.'s banking analyst Andrew Collins. Citigroup (Research) financial chief Sallie Krawcheck blamed the flattening yield curve for the company's lackluster second quarter.

To compensate, banks have been cutting costs and setting aside less in reserves to cover bad loans to boost earnings. But that strategy could backfire if credit quality starts to deteriorate.


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