The financial sector tends to be among the most sensitive to interest rates, with banks and other financial institutions often able to expand profit margins when yields are on the rise.
But it can get complicated. With the Federal Reserve’s aggressive hiking of rates over the past year pushing a closely watched part of the U.S. Treasury yield curve to its deepest inversion since 1981, banks can suffer. And that appeared play a role in the demise last week of Silicon Valley Bank, or SVB, analysts said.
Banks make money from what they call the interest-rate spread, or the difference between the lower interest rates they pay for deposits and other sources of funding and the higher rates they receive on the loans they make.
SVB’s customer base was heavily concentrated in tech startups and venture-capital funds who got a lot of funding during the era of near-zero interest rates. As a result, the bank’s deposit grew significantly in 2020 and 2021. The bank put a large chunk of the money in long-dated U.S. Treasury bonds and government-backed mortgage securities.
See: Silicon Valley Bank: Here’s what happened to cause it to collapse
However, the value of SVB’s securities slumped as higher interest rates triggered a historic bond-market selloff in 2022, putting a big dent in the value of SVB’s existing securities holdings.
“The banks are encouraged to buy Treasurys and mortgages because they get favorable risk-based capital treatment on those, so there was real incentive from the regulatory system for banks to buy their triple-A rated [bonds],” said Greg Swenson, founding partner of Brigg Macadam in London, U.K.
“But many ignore the fact that because the securities are triple-A rated and they’re guaranteed by the U.S. government [and] considered risk-free…that doesn’t mean that their value can not go down 15% or 20% with sharp interest rate moves, and that’s exactly what happened” to SVB.
At the same time, rising interest rates fueled by the Fed’s relentless hikes constrained tech firms of all sizes, forcing them to burn through the cash that previously sat as deposits at SVB.
As a result, the bank had to sell $21 billion of government bonds at a loss of $1.8 billion to meet clients’ withdrawal demand, as well as selling $2.25 billion worth of equity securities to bolster its financial position.
See: Bond-market recession gauge plunges further into triple digits below zero after reaching four-decade milestone
Last week, hawkish comments by Fed Chair Jerome Powell helped push the policy-sensitive two-year Treasury yield
above 5% for the first time since 2007. That saw the 10-year yield
at one point last week trade more than 100 basis points, or a full percentage point, below the 2-year yield — the deepest inversion of that measure of the yield curve since 1981.
Yields have since pulled back sharply following the SVB collapse, with the inversion of the curve lessening.
In normal times, longer-dated bonds typically yield more than shorter-dated bonds, but a negative 2s/10s spread means that the yields on shorter-dated Treasurys rise above those for longer-term ones, which suggests that investors factor in higher interest rates in the near term while expecting a recession to pull down rates over the longer term.
Adam Turnquist, chief technical strategist at LPL Financial, said higher interest rates tend to help the banking sector overall as banks’ net interest margins expand, but that’s limited when the yield curve is inverted.
Turnquist told MarketWatch he anticipated a peak in the net interest margins when the Fed hits the brakes on its interest-rate hikes sometime this year. That means an inevitable downturn of the difference between the interest paid by the bank and the interest it receives will occur right after the peak and weigh on the banking space.
See: Why bank ETFs are tanking despite regulators taking emergency steps to backstop depositors
U.S. stocks tumbled on Monday, with U.S. banks leading the losses. Shares of the SPDR S&P Regional Banking ETF
dropped 9.8%, while the SPDR S&P Bank ETF
sank 8.2% and the Invesco KBW Bank ETF
tumbled 9.9%, according to Dow Jones Market Data. The broader U.S. financial sector was also hit, with the S&P 500’s financials sector
The Dow Jones Industrial Average
fell 90.50 points, or 0.3%, Monday, while the S&P 500
lost 0.2% and the Nasdaq Composite
hung on to a gain of 0.4%.
“Part of it is more in the case of Silicon Valley Bank — they weren’t hedging at all. They had a very small amount of interest rate swaps on the books so they were basically long Treasurys and mortgages, which in retrospect, was a huge mistake,” Swenson told MarketWatch in a phone interview on Monday. “You would hope that the rest of the financial sector is better hedged — assuming there’s no liquidity crunch, so they can take advantage of higher rates.”
However, Swenson said with an inverted yield-curve, aside from frequently being an indicator of recession, it puts companies in the financial sector in a “very difficult situation” because their short-term borrowing costs are so high.