Post by Bond-Doc

We need to talk about why yield curve inversion is bad and Travis (@coloradotravis on twitter) said it best:

Banks “borrow short to lend long” which means they pay in short term rates and earn in long term rates and capture the delta.

So when the curve is steep enough, you can lend money into the economy (for, say, capex) and continually ‘roll’ (refinance) your cheaper borrow.

Now, banks don’t actually just pay/earn the rates on the treasury curve — it’s a little more complicated than that.

Still, treasury rates are a decent proxy for what’s going on elsewhere in part because they impact what’s going on elsewhere.

USTs define the rate at which you can earn money on your capital without pricing in default risk.

If you lend to a private business at 5% when USTs are at 2% and they’re solvent that works great, but you look silly if USTs are at 5%.

This is called the ‘risk free rate.’

Anyhow these banks are borrowing short and lending long & then all of the sudden the Fed jacks rates up and the curve inverts.

That’s problematic because now your arb trade becomes unprofitable as your roll your short term debt.

Curve inversion=bank business model inversion.

This is why curve inversions don’t predict recessions so much as. create them: they mechanically make lending unprofitable.

But what about the curve inversions that aren’t followed by recessions?

Well, look: there are other factors.

These other factors are things like, “how deep & how long is the inversion?” & “how big are the banks’ books” and we can reason about them fairly easily.

A short and mild inversion won’t catch that many people out — it’s just the portion of the book rolled during that period.

So you could hit a little bump, have banks take a bit of a hit, maybe lending softens a touch or something, but then the thing re-steepens and we all get back to lending profitably.

And if the banks’ books aren’t too big, maybe it’s just not that much capital that gets caught out doing ‘upside down lending’ and so it’s just a bit of a hit to bank profitability.

But a prolonged and deep inversion is a different story.

Now we’re talking about a lot of capital getting caught out, and a deeply unprofitable ‘arb-inversion.’

This sort of thing will really impact bank profitability, mechanically disincentivizing both new credit to the economy and refinancing of existing debts.

And that’s what causes problems.

And this inversion is very deep, and just keeps going.

And the final piece here is that bank loan books are pretty big. Why?

Well remember all those stimmy checks? Those became deposits, and your deposits are one form of how banks ‘borrow short.’

And as you’ve no doubt noticed, they don’t pay you jack shit.

So this form of depository borrowing is kinda great for them because they’re paying 10bps or whatever and capturing a fat spread.

Oh but one detail: these are demand deposits so like… they can just vanish at any moment.

Which is what happened with SVB.

And now that there’s been a big highly visible kerfuffle around deposits the banks creditors (note: this is you) are like, “wait a minute… treasuries and money markets pay a lot more than my bank deposits and they don’t blow up as much either.”

So what happens?

Well those deposits start to leave.

And that’s no good because this puts further pressure on the banks’ books, since the arb trade on deposits that you don’t pay jack shit to borrow is pretty juicy.

And while this is becoming a more complex picture, at the center of it all this is the curve.

The curve offering depositors better options.

The curve putting pressure on the profitability of lending arb.

The curve sitting on the economy’s chest like an elephant.

This will lead to wider credit spreads for longer, with private money failing to react to policy as strongly as we’d like in the future. It will not matter what the fed does to interest rates.