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Inverted yield curve puts US bank margins in the crosshairs

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Inverted yield curve puts US bank margins in the crosshairs

U.S. bank margins fell again in the second quarter, and the challenging interest rate environment could lead to continued pressure during the remainder of 2019.

After declining 4 basis points in the first quarter, bank margins fell 3 more basis points in the second quarter, with the industry's taxable equivalent net interest margin falling to 3.37% from 3.40% in the prior quarter.

Increases in interest rates helped push margins higher in 2017 and 2018, but the benefits of higher rates began to wane earlier this year as funding costs rose at a quicker pace than loan yields. The plunge in long-term rates in the first half of 2019 caused the yield curve to invert, putting even more pressure on earning-asset yields and accordingly bank margins.

Loan yields still increased in the second quarter, rising 15 basis points to 5.49%. The inversion of the yield curve in 2019, punctuated by sharp decreases in long-term rates, kept any material expansion in yields on longer-dated credits at bay.

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Loans tied to short-term rates received the biggest boost in the second quarter, but the increases were still mild. The average effective fed funds rate in the second quarter rose 66 basis points from a year earlier, but held flat with the prior quarter ahead of the Federal Reserve's expected rate cut in late July.

Meanwhile, the average yield on the benchmark 10-year Treasury plunged in the second quarter, falling more than 50 basis points from the year-ago period as fears of a global economic slowdown and continued trade war between the U.S. and China roiled the bond market.

In the second quarter, yields on longer-dated credits such as one- to four-family mortgages rose 1 basis point from the prior quarter.

The recent move in long-term rates stands in stark contrast to market activity in the fall, when the yield on the 10-year Treasury surpassed 3% and traded well above that level for several months. However, by the end of the second quarter, the benchmark rate had fallen close to 125 basis points since the peak in early November. The average yield on the 10-year Treasury was 2.34% in the second quarter, compared to 2.75% in the first quarter.

Banks with greater exposure to the long end of the yield curve could feel even more pain in the coming quarter. The 10-year Treasury yield has tested historical lows in recent weeks, hovering around the 1.6% level. Economists expect an average 10-year Treasury yield of 2.23% in 2019, down 67 basis points from the prior year. That stands in stark contrast to the 59-basis-point year-over-year gain in 2018.

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Increases in short-term rates offered a modest lift to yields on commercial and industrial loans. The expansion in C&I yields still failed to match the increases in short-term rates, in part due to competition. For C&I loans, the beta — or percentage of changes in fed funds over the last 12 months that banks passed on to borrowers — was 45%, down from 67% in the first quarter and 51% in the fourth quarter of 2018.

Spreads on C&I credits have been under pressure for much of the last nine years and contracted again in the most recent quarter. In the Fed's most recent quarterly senior loan officer survey, bankers said spreads on C&I credits to larger and middle-market firms contracted relative to their cost of funds for the second straight quarter.

Spreads had expanded two quarters ago, ending 35 straight periods of weakening. The most recent survey focuses on changes in lending standards and terms and featured responses from 73 domestic banks and 21 U.S. branches and agencies of foreign banks.

In the survey, a net 26.8% of banks responding reported weaker spreads on C&I loans to large and midsized firms, relative to the lenders' cost of funds. That compares to 27.2% of respondents reporting stronger spreads in the previous quarterly survey, from May.

Banks in the survey also reported weaker demand for C&I loans from large and middle-market firms for the fourth consecutive quarter.

While yields on C&I loans helped boost earning asset yields, banks felt pressure on deposit costs. The deposit beta rose to 63% in the second quarter from about 46% in the prior quarter and the 39% level experienced in the year-ago period.

Meanwhile, the beta on total loans and leases was slightly higher than the deposit beta in the second quarter. The overall loan beta was 66% in the first quarter, compared to 46% in the prior quarter and 57% in the year-ago period.

Loan yields are unlikely to increase at the same pace in the future. Long-term rates have been under pressure, the Fed cut short-term rates in July, and many market watchers expect additional cuts to follow. Deposit rates, meanwhile, might have peaked, but customers continue to shift funds into higher-yielding accounts, leading to elevated costs. That dynamic likely will prevent bank margins from rebounding soon.

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