December 20, 2017 / 8:17 PM / 9 months ago

Canada's flat yield curve flashes warning for bank profits

TORONTO (Reuters) - Canada’s yield curve is nearing inversion for the first time in a decade, potentially restraining the ability of the country’s banks and insurers to increase profits despite the Bank of Canada hiking interest rates.

Buildings are seen in the financial district in Toronto, January 28, 2013. REUTERS/Mark Blinch

The likely margin pressure comes as Canadian banks face earnings head winds due to stricter mortgage lending rules and new accounting rules that may increase volatility on profits..

Curve inversion, when long-term yields dip below short-term ones, has served as a harbinger of economic recession. Earlier this month, two U.S. Federal Reserve policymakers urged caution in raising interest rates due to the narrow gap between the two ends of the U.S. yield curve.

Canada’s curve is even flatter. The gap between 2- and 10-year yields, a benchmark measure of the yield-curve slope, has plunged from around 2.3 percent in 2010 to a spread this week of 29 basis points. The yield spread between 2- and 5-year bonds has narrowed to just 13 basis points.

Banks posted record profits this year and benefited

from higher margins after the central bank raised rates twice this year and are hoping for margin improvement in 2018, when more rate hikes are anticipated. BOCWATCH

While the rate increases have pushed up yields on short-dated bonds, long-term yields have been heading in the other direction since October. That could reduce the profits that banks tend to make from using short-term funding, such as deposits, to lend to businesses and home owners over a longer time frame.

“If you get to a point where you have an inverted yield curve I definitely would be making the case that we should be limiting our exposure to the Canadian banks,” said Bryden Teich, portfolio manager at Avenue Investment Management.

When Canada’s curve last inverted in 2007, the economy pushed into recession and prompted the Bank of Canada to slash interest rates. The S&P/TSX Capped Financial Index plunged 60 percent between May 2007 and February 2009.

Canada's yield curve nears inversion: reut.rs/2oDtgC9

“What we really want is for the five-year yield curve to go up, allowing for a greater contribution from our deposit base,” Royal Bank of Canada Chief Executive Officer Dave McKay told Reuters.

“As rates increase, we are able to recapture the margin compression that we’ve experienced in recent years as a result of declining rates.”

McKay added that RBC uses hedging to limit its risk.

In the fourth quarter of the 2017 financial year, four of Canada’s ‘Big Five’ banks - RBC, Toronto-Dominion Bank (TD.TO), Bank of Montreal (BMO.TO) and Canadian Imperial Bank of Commerce (CM.TO) - improved their net interest margins by benefiting from rate hikes by the Bank of Canada in July and September.

Bank of Nova Scotia (BNS.TO), which has a higher proportion of its business in emerging markets, recorded a small decline in its overall margin.

TD, which has the highest proportion of earnings coming domestic retail banking, had the biggest margin at 2.86 percentage points. BMO had the lowest proportion at 1.57 percentage points.

Barclays analyst John Aiken said he expects profit margins for Canadian banks to be “stable to positive” in 2018, rising by 2 basis points, on average, in the first quarter.

“That said, tempering our enthusiasm on margins, the domestic curve has flattened in recent months, on both a sequential and annual basis, while the overall yield curve has also ebbed,” he said.

The profitability of insurance companies could also be hurt if the curve inverts. Insurers invest premiums they receive in long-term assets so they can meet future claims.

“That is more difficult to do without risking capital loss when the curve is flat and yields are low,” said James Athey, senior investment manager at Aberdeen Standard Investments.

Editing by Denny Thomas and Jeffrey Benkoe

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