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Banks are ready to tighten lending if the yield curve inverts

Brian Cheung
FILE PHOTO: U.S. Federal Reserve Chairman Jerome Powell holds a news conference following a two-day Federal Open Market Committee (FOMC) policy meeting in Washington, U.S., September 26, 2018. REUTERS/Al Drago/File Photo

The banking industry is telling the Federal Reserve that a flattening yield curve could squeeze their businesses.

In the Fed’s quarterly survey of loan supply and demand in the U.S. over the third quarter of 2018, senior loan officers reported that they would tighten their lending standards if longer-term bond yields dip below short-term Treasury rates.

Loan officers told the Fed that while a flattening yield curve has not affected loan standards or pricing across nearly all categories, an inverted curve could signal a “more uncertain economic outlook” and lead to a deterioration in the quality of their existing loan portfolios.

“In addition major shares of banks reported lending would become less profitable and their bank’s risk tolerance would decrease in this scenario,” the Fed’s summary of the survey read.

The spread between the 10-year Treasury and the 2-year Treasury has decreased over the last five years. Credit: Federal Reserve Bank of St. Louis

The spread between the 10-year and 2-year Treasurys are still positive for the time being, but the last five years have seen a dramatic narrowing of spreads. In 2018 so far, the 10-year has increased slightly amid positive economic readings, helping yields rise from 2.40% at the start of the year to 3.14% currently.

But concerns are building as the Fed continues to hike interest rates, fueling fears that the yield is poised for further flattening. Goldman Sachs’s David Kostin wrote November 7 that the yield curve would suffer from a “bear flattening” as the Fed hikes rates five times to a target range of 3.25% to 3.5%, predicting that 10-year bond yield will only rise by 20 basis points to 3.4% in that scenario.

The next Federal Open Market Committee meeting is scheduled for December 18 and 19, where the Fed is widely expected to raise rates another 25 basis points.

In the survey, a number of banks said a hypothetical inversion would also force them to tighten their price terms, which could make it more expensive for consumers and businesses to get credit.

Pricing pressures are already being seen in the real estate space; a few banks said they had adjusted their price terms for both commercial real estate and residential real estate.

Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.

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