Not everyone is particularly sanguine about the Fed’s decision to allow supplementary leverage ratio exclusions to expire as scheduled at the end of the month.
This was a hot-button issue already. It scarcely needed to be further dramatized. In that respect, the timing of the recent Treasury selloff left something to be desired. The backup in rates and last month’s disastrous seven-year auction threw the SLR debate into stark relief. By the time Jerome Powell took questions after the March FOMC, the SLR question was a semblance of urgent.
Some worried allowing regulatory relief to expire could result in additional tumult for Treasurys. A record two-week drawdown in primary dealer positions (figure below) was confirmation bias for that crowd — the “preemptive” trimming of dealer inventories was just a taste of what’s coming, some folks suggested.
On March 16, with an announcement on the fate of the exclusions for Treasurys and reserves looming, Zoltan Pozsar contended that the market’s assumptions about SLR exemption expiration leading to large Treasury selling by US banks “is wrong.” “If the SLR exemption ends on March 31st, that won’t lead to forced sales,” he said. “Neither will it cause a constraint on the functioning of the Treasury repo market.”
That threw a spanner in the works for what was becoming the consensus narrative. Pozsar implicitly adopts a kind of Lefty Ruggiero cadence when it comes to debates that fall within his purview: “I’m always right. Even when I’m wrong, I’m right.” The financial media’s mythologizing only adds to the legend.
Read more:
Fed Waters Down SLR Expiration With Allusions To Modifications
But many analysts are sticking with it, where “it” means a contention that the expiration of SLR relief could cause problems for Treasurys. In a lengthy note out Friday afternoon, for example, TD’s Priya Misra and Gennadiy Goldberg warned on medium- and long-term ramifications assuming the Fed doesn’t implement carveouts or otherwise permanently rewrite the rules, as hinted at in the statement.
“While not all the implications will be immediate, we could see higher market volatility over time and less support for markets in times of stress,” Misra and Goldberg cautioned, noting that banks have three options: Shed deposits, shed assets, or shed repo. Pozsar on Thursday noted that the Fed’s decision to boost the counterparty limit on the RRP facility “suggest[ed] the Fed [was] ‘foaming the runway’ for the end of SLR exemption” which, he said, could “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.”
With that in mind, TD’s strategists wrote that banks “could try to incentivize corporations and individuals to move their cash from deposits to money market funds by imposing fees on deposits [but] such a shift could also burden money funds, who have already seen $120 billion of inflows this year in addition to $958 billion of inflows in 2020 and are already struggling to find attractive investments as front-end rates remain near zero.” Although the higher RRP limit should “help floor rates at zero, prevent repo from going significantly negative [and] help lower reserves,” Misra and Goldberg said they “are doubtful that it will make a big difference given that reserves are likely to increase to $5.6 trillion by year-end.”
Given the “limited ability to offload deposits,” banks might just decide to sell assets, TD said, noting that Treasurys “are particularly vulnerable as they are one of the lowest-yielding securities banks can hold.”
If you subscribe to that, it follows that banks’ demand for more Treasurys will be commensurately reduced, which is problematic. “SLR create[s] frictions for dealer intermediation, changing the Treasury market structure,” Misra and Goldberg said, reiterating points made on a number of occasions previous. “An expiration of the SLR exemption can reduce dealers’ ability to intermediate markets, which could in turn increase the volatility around market stress events, which include auctions.”
They run through several more potential outcomes, including lower repo availability or higher repo rates, lower front-end rates (i.e., as banks offload deposits to money funds, demand for front-end assets will be even stronger), a rockier year-end turn, and bear flattening pressure due to a combination of reduced demand for Treasurys and increased issuance.
This all sounds esoteric (and, for many market participants, it is), but the problem with ostensible arcana is that when it infrequently comes out of the shadows (or, more aptly in this context, climbs out of the plumbing and crawls up through your sink), it’s usually to cause problems.
As an aside, I’m not sure why anyone was still clinging to the notion that SLR relief was going to be extended. Between the somewhat agonizing delay around the announcement, political wrangling and, at the risk of accidentally contributing to the above-mentioned mythologizing, Pozsar’s March 16 note declaring that everyone was wrong to suggest the rates market would come “unglued” if the exclusions were allowed to expire, the writing was on the wall by Friday.
Now, we’ll see whether it matters. “An expiration of these provisions could contribute to the volatility in the bond market, resulting in higher yields and deteriorating liquidity conditions,” SocGen said Thursday. Writing just after the announcement Friday, Bloomberg’s Cameron Crise noted that “it would be ironic, and not altogether surprising, if Zoltan Pozsar is right, if this marked a temporary peak in yields now that the bogeyman has finally emerged from the closet.”
One thing I have observed over the past 15 years, is that when the Boomers scream loud enough that they want more juice, the Fed gives it to them.
Funny and true!