Richard Moody, like most economists, had his eyes and ears tuned to Federal Reserve Chairman Ben S. Bernanke in April, 2006 as he testified in front of the Congressional Joint Economic Committee in Washington, DC.

Before too long, Moody knew that Bernanke’s words would be greeted positively, if not with outright relief, by bankers as the Fed chief indicated that the string of consecutive interest rate hikes may be coming to an end.

"There is ... the possibility that if there is sufficient uncertainty, that we may chose to pause, simply to gain more information to learn better what the true risks are and how the economy is actually evolving," Mr. Bernanke told the Joint Economic Committee.

Within minutes of Bernanke’s comments, US Treasury yields began steepening, indicating that the long draught was over and that banks could expect to begin making some serious money again.

“There’s no doubt that bond market yield steepened after Bernanke’s comments,” said Moody later that afternoon. “When he hinted that the rate hikes could be over that fueled a steepening of the yield curve. For the first time in a long while interest rates are looking more normal than they have been.”

Why all the fuss about an innocuous comment from a just-getting-his feet-wet Federal Reserve chairman? And why would those comments have bankers dancing in the streets?

It’s simple, once you understand how heavily banks depend on a longer yield curve to make money. The variance between short and longer-term rates can significantly impact a bank’s profit margins. Everything from collecting deposits to credit-card operations to securities trading usually suffer when the yield curve trends flatter.

“What banks do is to borrow money at short term interest rates and lend them at long-term interest rates,” explains Moody. “Ideally, they want their assets to be of a longer duration than their liabilities. But when the yield curve is flatter – meaning that short-term interest rates and long-term interest rates have drifted closer together, it makes it much harder for banks to make money.”

“That’s how they make money . . . on that interest rate spread,” he adds.

In 2006 and through 2007, that spread has been narrower, and thus less profitable for lending institutions. In fact, early in 2006, the bond market recoiled after a rare “inversion” of interest rate yields, when short-term rates crossed paths with long-term rates, which historically has signaled an economic recession.

“Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession,” says Jim McWhinney, an economist with the financial advisory web site, Investopedia. “When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.”

When the yield curve flattens, or inverts, as it did briefly in 2006, profit margins fall for companies that borrow cash at short-term rates and lend at long-term rates, such as community banks. “Likewise, hedge funds are often forced to take on increased risk in order to achieve their desired level of returns,” he adds. “In fact, a bad bet on Russian interest rates is largely credited for the demise of Long-Term Capital Management, the well-known hedge fund run by bond trader John Meriwether.”

As yield curves narrowed, banks paid the price. Wyomissing-based Sovereign Bank recently announced that that its first-quarter net income fell three percent, with net income down $141 million from the previous quarter.

In a statement, Sovereign CEO Jay Sidhu pointed to "the prolonged flatness to slight inversion in the yield curve," as the primary reason for the bank’s sluggish performance.

Narrowing yield spreads hurt bigger banks, as well. While Bank of American boosted its net interest income to $30.7 billion in 2005, primarily due to its FleetBoston acquisition, its net interest margin, plummeted 33 basis points to 2.84% at the end of 2005 as the yield curve flattened. Analysts estimate that the narrowing yield spreads cost Bank of America several hundred million dollars in earnings.

Traditionally, bank managers treat a narrowing yield curve the way they would a nasty case of the flu – they suffer through it and try to wait it out.

“That’s pretty much all you can do,” says Richard Elko, CEO of the fledgling Conestoga Bank, which is set to open its doors sometime this summer. “The art of running a bank is matching up the maturities of your assets and liabilities and that can’t always be done perfectly.”

“Consequently, it makes crafting that at much harder to do when spreads are tightening.”

While banks have smartly moved into non-yield curve impacting markets, like fee-based asset management and merger financing, the need for heavily depending on those areas as profit centers is dissipating. Banks are now getting to the point where bond investors see the yield picture as normal. These things go in cycles and we seem to have carried through to a new phase in the yield climate.

Seems like Ben Bernanke might agree.