After an agonizing delay, the Fed finally made an announcement on supplementary leverage ratio relief.
Temporary exclusions were, in fact, temporary. Exemptions for Treasurys and central bank reserves will expire, as scheduled, on March 31, the Fed said.
Notably, the short statement was replete with cautionary language, pseudo-caveats and what amounted to the Fed insisting that it understands the issue and is prepared to have a running dialogue.
“The Treasury market has stabilized. However, because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the Board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability,” the Fed said, adding that a public comment period will soon begin for potential SLR modifications.
The market became obsessed with the SLR issue during the recent Treasury rout. The hand-wringing revolved around the idea that if exclusions were allowed to expire, dealer “adjustments” (to employ an amusing euphemism) could exacerbate tumult in the bond market. Primary dealers trimmed Treasury positions by the most ever in the week through March 3, and shed another $16.1 billion last week (figure below).
During the post-FOMC press conference Wednesday, Jerome Powell said an announcement was forthcoming, which meant Friday.
Earlier this week, the incomparable Zoltan Pozsar suggested everyone fretting about the SLR extension was wrong. To recap, he wrote the following in a note dated March 16:
The market assumes that the SLR exemption is what has “glued” the rates market together since 2020, and that the end of exemption means that large U.S. banks will have to sell Treasuries. That view is wrong: if the SLR exemption ends on March 31st, that won’t lead to forced sales, neither will it cause a constraint on the functioning of the Treasury repo market. Where are most of the exempt reserves and Treasuries booked? Close to 90% of the exempt reserves and Treasuries are booked at G-SIBs’ bank operating subsidiaries. Broker-dealer subsidiaries hold only about 10%. Put differently, the pandemic-driven surge in reserves and Treasury holdings occurred in bank portfolios, not in dealer inventories. Second, what will happen to bank portfolios if the SLR exemption ends? Nothing. The exemption of reserves, Treasuries, and net repos from the SLR was optional at the bank operating subsidiary level, but the major banks did not opt in because they didn’t want to get tangled up with the strings attached –seeking approval from regulators prior to making capital distributions from the bank operating subsidiary to the holding company in exchange for an exemption. Put differently, the exemption of reserves, Treasuries, and repos never happened at the bank operating subsidiary level, so when the “option expires” on March 31st SLRs at the bank operating subsidiary level won’t change at all.
On Wednesday evening, following the Fed, he cited the decision to boost the counterparty limit on the RRP facility as evidence that SLR exemptions likely wouldn’t be extended.
“The fact that the Fed made this adjustment practically preemptively — the o/n RRP facility is not being used at the moment, so there are no capacity constraints yet, while repo and bill yields aren’t trading negative yet — suggests the Fed is ‘foaming the runway’ for the end of SLR exemption,” Pozsar said, adding that “ending the exemption of reserves and Treasuries from the calculation of the SLR may mean that US banks will turn away deposits and reserves on the margin (not Treasuries) to leave more room for market-making activities, and these flows will swell further money funds’ inflows coming from TGA drawdowns.”
It’s possible that, due in part to the hype, the market will react negatively to the decision not to extend the exclusions. Futures volumes in Treasurys surged following the announcement.
To the extent the market does believe its own hype, the Fed’s careful language could help allay concerns once any knee-jerk moves fade. Bloomberg cited NatWest’s Blake Gwinn. “I was never worried about a day-one bank puke of Treasuries or drawdown in repo or anything like that on no renewal,” Gwinn said. “My concern was [as] reserves continue to rise, would the SLR become a nuisance and drag on Treasuries and spreads?” The Fed, Gwinn remarked, is “really speaking to those fears and basically saying, ‘don’t worry, we are on it’.”
Coincidentally (or not), Jerome Powell published an Op-Ed in The Wall Street Journal around an hour after the SLR announcement was posted. Obviously, no one who cares about SLR exemptions is interested in hearing Powell retell the generic version of the pandemic story again, but it’s at least possible that the Fed timed the release to coincide with any potentially adverse price action that might develop in the intervening 60 minutes.
“The recovery is far from complete, so at the Fed we will continue to provide the economy with the support that it needs for as long as it takes,” Powell promised.