Currently, factors such as low unemployment and increases of the federal funds rate by the Federal Reserve reflect a strong economy. In this climate, demand for bank loans increases and bank profitability should improve. There has been a sharp increase in the yield on U.S. 2-Year T-Notes, but despite this rise, the U.S. 10-Year T-Note yield has failed to remain above 3%. That failure of the U.S. 10-Year T-Note yield is mostly due to the recent decline in the German 10-Year Bond yield.
Three separate interest rates impact the profitability of U.S. banks and growth in the brokered CD market: Yield on the U.S. 2-Year T-Note, yield on the U.S. 10-Year T-Note, and yield on the German 10-Year Bond. In a strong economy with an increase in bank loan demand, bank profitability improves, if the U.S. 10-Year T-Note yield is allowed to increase. This increase, in turn, will impact mortgage and bank loan rates. The recent, significant increase in the 2-year T-Note yield to 2.7% and increase in the federal funds rate to 2% raised bank costs of deposits. Therefore, in today’s interest rate environment, a 10-Year T-Note yield of 3% to 4% seems reasonable. However, an increase in the U.S. 10-Year T-Note yield is constrained by the German 10-year Bond yield.
Chart I shows how U.S. and German 10-Year Bond yields have performed similarly over time. Since 2015, the European Union and German central banks have been determined to maintain a near-zero yield on the German 10-Year Bond, in order to stimulate growth in the European economy. In early 2018, this Bond yield was allowed to increase above 0.5%, which provided the opportunity for the U.S. 10-Year T-Note yield to increase (see Chart I). However in the last few months, German Bond yield has retreated below 0.4%. Despite the significant increase in yield in the U.S. 2-Year T-Note, the decrease in the German Bond yield has caused the U.S. T-Note yield to retreat below 3%.
The failure of the U.S. 10-Year yield to rise above 3% limits the rate banks charge on loans, and, with higher deposit costs, reduces bank profitability. The German 10-year Bond yield, therefore, currently holds U.S. banks hostage, by limiting 1) increases in loan rates, 2) bank profitability, and 3) growth in the brokered CD market.
The German 10-Year Bond yield is primarily controlled by the European Central Bank. The German economy is strong, with 4% nominal GDP growth, paralleling U.S. GDP growth. The growth in U.S. GDP indicates a rise in the U.S. 10-year Bond yield to 4% in 2019 (see Chart II). However, the growth of Germany’s economy is hidden, since, as part of the Euro currency, that growth is averaged with all other countries included in the Euro. Despite a booming economy, Germany can use the Euro currency to maintain low prices.
Controlling the 10-Year Bond yield and the Euro Currency also allowed Germany the opportunity to take advantage of the U.S., with cheaper exports, reduced long-term interest rates, and high tariffs on U.S. exports to Europe. However, agreements between the EU and the U.S., as highlighted in new talks, could call for no tariffs and free trade on manufactured goods, shifting this imbalance.
IDC Financial Publishing, Inc. (IDCFP) has been rating the safety and soundness of banks, savings institutions, and credit unions since 1985. Our track record and IDC's bank rating methodology has made IDCFP the standard in ranking financial institutions. For more information or to view our products and services please visit our website at www.idcfp.com or contact us at 800-525-5457 or email@example.com.