Financial shares led the market in August, boosted by rising expectations of an imminent interest-rate hike — but their advance could be short-lived, analysts said.

The shrinking gap between short- and long-term U.S. Treasury yields — a phenomenon that is known as a flattening yield curve — is threatening bank profitability as it compresses lenders’ net interest margin, or the difference between the interest they earn on the loans they make and the interest they pay out, leading to lower earnings.

The yield curve describes the differential between short-term and long-term Treasury yields — typically two-year notes and 10-year Treasury notes. Normally, the shape of the curve slopes upward as investors demand greater yields to compensate for the risk of lending money over a longer period. So, a flat yield curve can be read as investor bets that the economic outlook is weakening.

Recently, yields at the front end of the curve, which represents short-term Treasurys, have risen. That boosted financial shares, leading the Financial Select Sector SPDR ETF XLF, -1.40% one of the most popular ways for investors to play the broader industry, to post its best daily performance in weeks. The S&P 500 SPX, -0.93% financial sector was the top performer in August, posting a 3.6% rise.

But the optimism could be short-lived, analysts said, as the moves in short-term yields were in contrast to the back end of the curve, which has seen yields fall. That’s left the curve near its flattest since the end of 2007.

On the one hand, recent hawkish comments by Federal Reserve policy-makers have boosted the market’s interest-rate-hike expectations, nudging short-term yields higher.

On the other hand, long-term yields are still expected to remain lower for longer, as tepid inflation expectations in the U.S. and dovish central banks in Europe and Japan keep a lid on yields.

For example, the yield differential, or spread, between long- and short-term Treasurys, in this instance between the benchmark 30-year TMUBMUSD30Y, -0.36% and the two-year TMUBMUSD02Y, -1.09% Treasury note, has been steadily narrowing.

On Monday, the gap reached its tightest level since the end of 2007 at 142.2 basis points. In other words, investors demanded a yield premium of just over 1.4 percentage points to loan money to the government for 30 years rather than two. Over the past decade, that premium typically has been between 2.5 and 3 percentage points.

A flattening yield curve is bad news for banks, but fortunately that is only one of the factors that affects their profitability, said Diane Jaffee, senior portfolio manager at TCW.

Jaffee pointed to commercial and industrial loans, which have risen in August at an annualised rate of 8.6%, while the one-month Libor index, which serves as a benchmark for bank-loan pricing, has more than doubled since October 2015. Labour and short-term money-market rates have risen since earlier this summer in anticipation of a rule change that takes effect in October.

Still, many analysts worry that long-term Treasury yields could remain on the floor as inflation stays relatively tame, below the Fed’s 2% target. Ultralow yields or negative yields across much of Europe and Japan also help underpin demand as global investors seek out relatively higher-yielding U.S. paper.

On Monday, long-term yields logged their largest daily drop in nearly two months after the PCE index, the Fed’s preferred inflation barometer, showed an annual rate of core inflation at 1.6%.

A significant rise in inflation would tend to push long-term yields higher, as investors would require richer compensation to hold on to a long-term investments amid rising prices.

Long-term yields “cannot rise too much,” given that inflation’s “upward trend has stalled,” said Collin Martin, director of fixed-income strategy for the Schwab Center for Financial Research.

 

 

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