One of the big themes facing investors is the recent sharp run-up in bond yields in Canada and the United States. Bond investors see gathering economic strength, rising momentum in inflation and – ultimately – a more rapid pace of interest rate hikes from the U.S. Federal Reserve Board and the Bank of Canada.

That’s a positive for banks and their bottom lines. Let’s take a closer look.

There was a time when rising interest rates were considered a negative for banks. As loans became more expensive, the thinking went, consumers and businesses would become increasingly reluctant to take out loans. It wouldn’t take long before sagging loan demand hurt banks’ profit growth.

Today, the concern over rising rates and loan-demand is still present, but manifests itself in a different way. Years of ultra-low interest rates have contributed to sky-high household debt levels. (At last count, the average Canadian owed $1.69 in debt for every dollar of assets they owned). We often hear economists say the carrying costs of those debts are manageable at low interest rates, but when rates rise meaningfully, some Canadian households won’t be able to cope. That, in a very different way, will blunt loan demand.

But, by far, the most consequential way to think about banks and interest rates is net interest margin. This is the spread between the rate of interest a bank pays out to depositors, and the rate of interest it receives from borrowers who have taken out loans. NIMs, as they are called, play into net interest income – a huge portion of a bank’s overall revenue stream. 

Over the past decade, Canada’s banks have bulked up their fee-based wealth management operations as a way of becoming less reliant on rates for profit growth – but net interest income is still vitally important. In its most recent quarter, Royal Bank of Canada’s net interest income amounted to just under 42 per cent of total revenue. It’s worth noting that, net interest income is a top-line figure, not an after-expenses bottom-line figure.

Seen through the lens of net interest margin, then, higher rates are a positive for banks. As rates rise, so should net interest margin and net interest income. In recent quarterly reports, the Canadian banks have cited wider spreads as one of the factors contributing to profit growth. And you can expect more of the same. 

Since the end of the banks’ third quarter on July 31, the yield on the Government of Canada 10-year bond has increased by 17 basis points (to 2.48 per cent at this time of writing) and the Bank of Canada stated in its Sept. 5 rate announcement that “higher rates will be warranted to achieve the inflation target.” The central bank also said it was closely monitoring the then-tense NAFTA talks, and – of course – a new NAFTA pact has since been achieved.

There is another dimension to the relationship between bank profits and rates, and that is the shape of the yield curve. Conventional wisdom has long held that a steepening yield curve – long-term rates rising faster than short-term rates – is not only positive but almost essential for healthy bank profit growth. That’s because banks fund themselves largely by selling bonds in the short-term bond market, where rates are typically lower, and lend to customers for longer terms, where rates are typically higher.

A flattening yield curve, when short-term rates rise faster than long-term rates, and thus squeeze the spread between the two, is typically seen as a negative.

And flattening has been the trend of late. As the U.S. Federal Reserve and the Bank of Canada have hiked rates in recent years, the short end of the yield curve has risen faster than the long end. Some bank watchers fear the flattening trend in the yield curve will blunt the positive effect of higher rates.

But not everyone agrees.

Gordon Reid is a frequent guest on BNN Bloomberg, and a frequent guest co-host with me on The Street. Earlier this year, he and his colleagues at Goodreid Investment Counsel published some research on banks, rates and the yield curve. Their conclusion: rising rates are a positive for bank profits, regardless of directional changes in the shape of the yield curve.

Big U.S. banks routinely disclose their earnings sensitivity to yield-curve trends, Goodreid notes, and have said their profits rise substantially in a flattening yield curve environment – if the flattening is the result of the short end rising.

Canadian banks don’t provide the same level of disclosure, but Goodreid believes their relationship to yield curve can be inferred “at least directionally” by comparing the makeup of their assets and liabilities over different points on the curve.

“Accordingly, we emphatically refute the conventional wisdom that a flattening yield curve spells doomsday for the banks – the facts simply don’t bear this out.”

What investors really need to understand, Goodreid says, is that – simply put – a general rise in rates is a plus for banks and their profit growth.

You can expect Canadian CEOs to echo that sentiment when the fourth-quarter earnings results begin appearing in late November.