Navigating the Shifts in the Yield Curve: Implications for Banks and Credit Unions

The past 12 months have been marked by significant changes in the interest rate yield curve, presenting both challenges and opportunities for banks and credit unions. These shifts, influenced by macroeconomic trends, monetary policy adjustments, and market expectations, require financial institutions to reassess their strategies and risk management frameworks.

Understanding Recent Changes

The yield curve, which plots interest rates across different maturities, has experienced:

1. financial institutions to reassess their strategies and risk management frameworks.

   Understanding the Recent Changes

   The yield curve, which plots interest rates across different maturities, has experienced:

   1. Normalization Trends: Over the past year, the yield curve has transitioned from inversion to a more typical upward slope. This reflects a moderation in market expectations for recession risk and a stabilization of monetary policy.
      • Today vs. 12 Months Ago: A year ago, the yield curve was inverted, with short-term Treasury yields (e.g., the 2-year) exceeding long-term yields (e.g., the 10-year) by approximately 50-70 basis points. Currently, the yield curve has normalized, with the 10-year Treasury yield exceeding the 2-year by about 30-50 basis points.
   2. Rising Long-Term Rates: Long-term rates have increased due to shifts in inflation expectations and Federal Reserve signaling of a higher-for-longer rate environment.
      • Today vs. 12 Months Ago: The 10-year Treasury yield has risen from around 3.5% a year ago to approximately 4.7% today, while short-term rates (e.g., the 2-year Treasury) have moderated slightly from their peak near 5.0%.
   3. Recession Risk: Although the 3-month and 10-year Treasury yield spread has turned positive for the first time since October 2022, easing some recession fears, history shows that such reversions often precede recessions. Over the past 40 years, recessions have typically followed 2 to 12 months after the yield curve un-inverts.
      • Today vs. 12 Months Ago: With the curve just turning positive, the recession risk window has not closed but rather has just opened.

   These developments have profound implications for balance sheet management, profitability, and strategic planning.

Risks Created by a Normalized Yield Curve

1. Interest Rate Risk: A steepening yield curve may create challenges for institutions reliant on short-term funding while holding long-term fixed-rate assets, creating additional NIM compression.
   • Duration Mismatch: Changes in rates can disrupt the balance between asset and liability durations, increasing exposure to interest rate fluctuations and deposit GAP.
2. Liquidity Risk: Shifts in market conditions may lead to tighter liquidity, particularly for institutions heavily reliant on wholesale funding.
   • Many FIs were hoping reduced rates in 2025 would allow them to reposition bond portfolios that are currently in a loss position, allowing them to boost NIM. Higher for longer rates will throw a wrench into this strategy.
3. Credit Risk: Higher rates can pressure borrowers, increasing the likelihood of delinquencies and defaults, especially on adjustable-rate products.
   • Commercial Real Estate portfolios that are repricing into higher rates will continue to be a much higher risk to FIs with high exposure to this asset class.

Strategies for Managing Increased Risks

To navigate the complexities of a changing yield curve, banks and credit unions can adopt the following measures:

1. Enhanced Asset-Liability Management (ALM): Regularly update ALM models to account for changing rate scenarios using dynamic modeling vs static. Use derivatives to mitigate interest rate risk, such as interest rate swaps or caps.
2. Diversified Funding Sources: Reduce reliance on short-term funding by exploring longer-term deposits or wholesale funding options.
3. Stress Testing: Conduct rigorous stress tests to assess the impact of extreme rate scenarios on capital, liquidity, and profitability.
4. Customer Engagement: Proactively communicate with borrowers about potential rate impacts, offering restructuring options or financial counseling as needed.

Seizing Opportunities Amid Challenges

While risks abound, the shifting yield curve also presents opportunities:

1. Strategic Pricing: Adjust deposit and loan pricing to align with market conditions, optimizing spreads and non-interest income sources.
2. Portfolio Adjustments: Capitalize on higher long-term rates by adjusting investment strategies to capture enhanced yields.
3. Product Innovation: Develop products tailored to changing customer needs, such as rate-lock options or hybrid loan structures.

Conclusion

The evolving interest rate yield curve underscores the need for agility and proactive management in the financial sector. By implementing robust risk mitigation strategies and leveraging new opportunities, banks and credit unions can not only weather the current challenges but also position themselves for long-term success in an unpredictable economic landscape.