Bankers should be looking at the inverted yield curve with real alarm

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In 2006, I embarked on my career as a banker, freshly armed with insights from experts such as Nicholas Souleles of the Wharton School of Business. I read an article by him entitled Don't Sweat the Inverted Yield Curve: No One Really Knows What It Means," which was published shortly after the yield curve inverted for the first time in five years. In it, he quoted a Wharton finance and management professor saying, "I think [the inverted yield curve] sometimes portends a recession, sometimes not."  The general consensus of the article: Economic activity looks positive, don't worry about the inversion.

Yet, within mere months, the world was plunged into the depths of the Great Recession.

The yield curve is a graphical depiction of interest rates for bonds of the same quality but varying maturities. A normal curve often suggests growth, while an inverted one frequently heralds a recession. It's a tool used to gauge market expectations of future economic activity.

The shape of the yield curve is often thought to reflect market expectations of future interest rates, and this idea is commonly known as the "expectations theory." This theory can give clues about future interest rates and economic activity.

March 2022 marked the first yield curve inversion since 2019. Currently, the curve shows nearly a 100-basis-point difference between the shortest- and longest-term rates, against a backdrop of the Federal Reserve significantly reducing the M2 money supply.

Unlike 2006, when bad credit underwriting and fraud ignited a recession, I believe the next downturn may stem from a banking liquidity crisis. Rising consumer debt, restarted interest accrual on federal student loans, burgeoning business costs and a fragile commercial real estate sector might fuel this crisis.

The most recent Household Debt and Credit Report from the Federal Reserve Bank of New York shows that student loan debt currently stands at $1.57 trillion dollars and total household debt rose by $16 billion in the second quarter of 2023 to reach $17.06 trillion. The report notes that "Credit card balances saw brisk growth, rising by $45 billion to a series high of $1.03 trillion," indicating that consumers are in trouble.

Moreover, with over $3.2 trillion in loans linked to fluctuating short-term secured overnight financing rates, businesses now face substantially higher interest payments than in previous years. This escalation not only tightens available cash for investment and hiring but also strains operating budgets.

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Compounding these financial pressures, the average price of electricity per kilowatt hour has risen sharply by 20-30%. This surge in energy costs threatens to drive up prices across the board, impacting food, goods and services and placing additional burdens on both businesses and consumers.

What this means is that banks are in trouble.

The financial landscape is currently riddled with warning signs that point toward potential liquidity issues for banks. An inverted yield curve, historically a precursor to economic downturns, suggests that short-term borrowing costs for banks could soon outpace the returns from long-term loans, squeezing profit margins.

Compounded by a shrinking M2 money supply, banks face challenges in lending and maintaining liquidity. Soaring consumer and student loan debts, coupled with vulnerabilities in the commercial real estate sector, further threaten banks with higher default rates and potential write-downs.

Businesses, strained by mounting debt and surging energy costs, are at risk of missing loan repayments, exacerbating banks' liquidity concerns. The recent collapses of major banks highlight the fragility of the sector, with the potential to trigger panic withdrawals and further liquidity strains.

This confluence of factors paints a concerning picture of the future solvency of the banking industry.

Don't be misled by pieces that downplay the importance of the yield curve. Such articles often overlook a critical point: An inverted yield is an anomaly. Its very occurrence contradicts the fundamental principle of the time value of money, which emphasizes the greater utility of possessing money now rather than later.

The collapses of Silicon Valley Bank, First Republic and Signature Bank may be harbingers of what's to come. The inverted yield curve might be warning us that more bad news lies ahead. I sincerely hope I am wrong, but the signs are troubling.