July 12, 2024

Banking on Resilience: How Banks are Preparing for a Recession Amidst Soaring Treasury Yields

Image Credits: Mandel Ngan/Agence France-Presse/Getty Images

The financial world is buzzing with anticipation and concern as Treasury yields reach new heights, posing a potential threat to the banking industry’s stability. Bank stocks are facing the possibility of annual losses due to the adverse effects of sharply rising interest rates. However, amidst these challenges, the industry has a surprising ace up its sleeve – the highest level of reserves in three decades, as reported by DBRS Morningstar.

The Relentless Surge in Treasury Yields

Bank shares have been under mounting pressure since the Federal Reserve signaled in September its intent to maintain higher interest rates for longer than expected. This firm stance from the central bank has overshadowed this year’s stock market rally. Still, it has rekindled a dramatic selloff in the approximately $25 trillion Treasury market.

Kathy Jones, Chief Fixed-Income Strategist at Schwab Center for Financial Research, paints a clear picture: “Right now, nothing is standing in the way of higher Treasury yields. It’s fairly obvious it’s not good for banks. The rise in yields has just been relentless.”

The rise in yields impacts banks in two significant ways. Firstly, it erodes the value of portfolios containing lower coupon debt issued when interest rates were lower. Secondly, banks often hold substantial exposure to commercial property loans, which could become increasingly difficult to refinance if rates remain elevated.

Currently, the S&P 500 index’s financial sector is down 5.5% for the year, according to FactSet. The popular Financial Select Sector SPDR ETF XLF has also experienced a 5.5% decline in 2023.

Banks Fortify Their Reserves

Despite the challenges, the banking industry has been quietly bolstering its reserves. DBRS Morningstar analysts Eric Chan and Michael Driscoll believe that while credit losses may continue to rise, the banking reforms implemented in the wake of the 2007-2008 global financial crisis have positioned the industry to “weather any potential storms.”

Kathy Jones at Schwab concurs, stating, “That’s logical. They are saying: Things don’t look so great right now. I’m going to have to be more careful.”

In the second quarter, banks were exposed to an estimated $558.4 billion in unrealized losses on underwater securities, marking an 8.4% increase from the previous quarter, according to the Federal Deposit Insurance Corp.

Commercial Real Estate Exposure and Regional Banks

Regional lenders, in particular, have significantly increased their exposure to commercial real estate when interest rates were at historic lows in recent years. The potential fallout from higher rates or a recession has become a focal point for the Federal Reserve and the Treasury Department.

The selloff in bank stocks this year has hit regional players the hardest. The SPDR S&P Regional Banking ETF KRE is down approximately 32% for the year, as Dow Jones Market Data reported.

Silicon Valley Bank’s collapse in March sent shockwaves through the industry after it sold an extensive portfolio of securities at a sharp loss. The Federal Reserve established an emergency lending facility to provide banks with liquidity and prevent forced asset sales. Demand for this facility spiked in September, helping to restore confidence in the banking industry.

Treasury Yields: Where to Next?

The ascent of longer-dated Treasury yields has substantially diminished U.S. bond market returns for the year. The popular iShares Core U.S. Aggregate Bond ETF AGG recently closed at its lowest level since October 2008.

Currently, the 10-year Treasury yield stands at 4.80%, with the 30-year Treasury rate knocking on the door of 5% at 4.92%, the highest level in about 16 years, according to FactSet.

Kathy Jones at Schwab suggests that the 10-year Treasury yield may need a catalyst to reverse its course but acknowledges that it could reach 5% or even 5.5% this year in a “vastly oversold” scenario.

As the Dow Jones Industrial Average turns negative for the year and the S&P 500 index trims its yearly gains, the financial world remains on edge, closely monitoring the impact of soaring Treasury yields on the banking sector and the broader economy.

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