After days of fevered speculation, the Federal Reserve did not extend relief on bank capital rules on Friday, sending long-term U.S. bond yields higher.
Investors and bank lobbyists had called on the U.S. central bank to extend the relief measures it introduced last April at the onset of the pandemic regarding banks capital requirements before a looming March 31 deadline, amid worries the bond market would come unanchored if demand for government debt abated.
“Part of the selling in bonds is related to the expectation that the Fed will allow this exemption to expire on March 31st. Traders are trying to get in front of it,” said Patrick Leary, chief market strategist and senior trader at Incapital, in a Thursday note.
During the early days of the pandemic, regulators had allowed banks that act as brokers, or middlemen, in the roughly $20 trillion Treasurys market to exempt U.S. government bonds from being treated as assets in calculations of the so-called Supplementary Leverage Ratio (SLR), a move some have cited for encouraging banks to increase their holdings of Treasurys.
It was one of many measures the Fed deployed in the wake of the coronavirus pandemic to encourage banks to keep lending to households and businesses.
Under the current leverage rules, banks must have capital equal to at least 3 percent of their assets, with that share rising as high as 5% for large banks, the so-called systematically important financial institutions.
According to some market participants, the continued exemption would have helped cap the rise in long-term bond yields that have contributed to the March volatility seen across the rest of Wall Street.
The 10-year Treasury note yield
was at 1.74% on Friday, near its highest levels since Jan. 2020, and off around 6 basis points from its intraday low.
However, Fed Chairman Jerome Powell was facing political pressure in terms of not cutting banks any more slack.
Democrat senators Elizabeth Warren and Sherrod Brown have said an extension of the SLR exemption would amount to a “grave error,” representing a rollback of the regulatory regime that has strengthened the robustness of bank balance sheets, after several major storied institutions collapsed during the 2008 financial crisis, while a string of others required bailouts.
Yet even though the Fed has phased out the exemption, the statement of the Fed’s announcement suggests the matter is not final.
The U.S. central bank noted the increased issuance of Treasurys this year to fund a sharply widening government budget deficit meant it could still tweak the SLR “to prevent strains from developing that could both constrain economic growth and undermine financial stability.”
Regardless, there are signs banks weren’t going to wait for clarity from the Fed either way.
The most recent data on the holdings of primary broker-dealers at banks, which trade directly with the Fed and U.S. Treasury, showed their net bullish positions in U.S. government bonds had fallen around $80 billion in the past two weeks to a net $169.8 billion in the week ending March 10.
“We doubt the dealer deleveraging is directly driven by the affected banks needing to sell Treasuries to adjust their capital ratios, but rather it is likely the dealer desks preparing for potential market volatility heading into March 31,” said Thomas Simons, senior money market economist at Jefferies, in a Thursday note.
Yet, despite the hubbub over the SLR rules, there also have been plenty of skeptics about whether an extension of the capital relief would be as meaningful to the bond market, as some had made it out to be.
Mark Cabana, head of U.S. rates strategy at BofA Global Research, had dubbed the issue a “red herring.”
He noted that many market participants may be giving too much weight to the SLR rules as an immediate driver of Treasurys trading, but he did see one place where phasing out the relief could potentially hamper the bond market down the road.
Without relief, banks may lack the capacity to resolve moments of indigestion in the Treasurys market which have cropped up as somewhat of an issue as investors shed government debt throughout this year.
“For most investors, this is potentially a cause of market indigestion, not a major risk to positioning,” said Lauren Goodwin, economist and portfolio strategist for New York Life Investments, in an interview.