Citigroup (C), Wells Fargo (WFC), Bank of America (BAC) and Steep Yield Curve

This weekend, it is news from Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Citigroup (NYSE:C) that losses from litigation related to mortgages made during the housing boom may lead to greater losses than the banks are currently provisioned for. The numbers are based on a total, worst case scenario, which must be disclosed due to a new SEC filing. While the headline of this story makes it a potential negative for banking shares this week, I believe investors who look past the headline will find shares of the large U.S. banks (I am including Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) in this category, since they are now bank holding companies) to be attractive due to the steep yield curve, expanding U.S. economy, increasing return of capital to shareholders, and a desire by the federal government to see banks succeed.

The yield curve, as defined by the difference between the 2-year and 10-year U.S. government bonds, is a very reliable tool in predicting the future of the U.S. economy in the intermediate term. The logic is that as the Federal Reserve cuts short term interest rates to fuel an economic expansion, investors react by predicting the Fed will be successful. This leads investors to sell longer dated bonds, allocating capital to either other asset classes will provide better returns, or for fear that inflation will rise and eat away at the real returns investors would get from longer dated bonds. A steep yield curve is therefore a sign the bond market expects strong growth, and an inverted, or negative yield curve is a prediction that economic growth is about to stop, or perhaps contract. Out of the 33 recessions in the U.S. since 1850, only twice has an inverted yield curve failed to predict a recession, in 1966 and again in 1998. The current spread between 2's and 10's is 2.67, off its highs of 2.92, but still more than triple the average spread since 1976 of 0.84. That means the bond market is signaling a continued strengthening in U.S. economic growth.

Aside from signaling a strong economy, a steep yield curve should signal strong bank profits.





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