Treasury Dealers Offload Bonds as Regulatory Deadline Nears

The Treasury market selloff last week came amid signs investors are deleveraging. In a curious twist though, instead of dealer inventories rising as a consequence, they unexpectedly collapsed.

Treasury holdings at primary dealers dropped by a record $64.7 billion to $185.8 billion in the week through March 3, leaving them at the lowest since 2018, according to data from the Federal Reserve released on Thursday.

Typically when investors offload Treasuries, dealer inventories balloon, as they did in March last year amid the early stages of the pandemic. The breakdown of the most recent data shows the bulk of the decline came from position reduction in under six-year Treasury paper, where holdings fell by $30.8 billion.

Treasury Dealers Offload Bonds as Regulatory Deadline Nears

One explanation for the disconnect is that dealers are taking steps to trim holdings before the expiry of a key regulatory exemption on March 31. From April last year, banks have been allowed to exclude Treasuries and reserves when calculating their supplementary leverage ratio as part of crisis measures introduced then. This allowed them to hold more Treasuries than they otherwise may have done.

“Dealers selling into the downtrade is consistent with the choppy price action seen during the last several weeks and concerns that ballooning net issuance could be problematic for liquidity conditions,” BMO Capital Markets strategists Ian Lyngen and Ben Jeffery wrote in a note. That’s “particularly in the event the preferential treatment for Treasuries is lost.”

The scale of selling so far may just be the tip of the iceberg. Should the exemption elapse at the end of the month, BMO sees room for more than $200 billion in Treasury bond selling. It may also have “serious implications” for bank capital and the Treasury market, and create balance sheet constraints and impair market functioning around stress events, according to TD Securities.

Read more on SLR deadline:
JPMorgan Sees Funding Shocks Should Fed’s Regulatory Relief End
Bond Traders on Edge as Clock Ticks on Fed’s Regulatory Relief
Cash-Rich Banks Drive Swaps Market Distortions: Liquidity Watch

Investors got a taste of these implications in recent weeks, when a Treasury-led selloff was marked by a surge in volatility and a drop in liquidity. A gauge of short interest, the cost of borrowing the current 10-year note in the market for repurchase agreements, has shot up in the past two weeks.

Fed officials opted not to provide any guidance on the topic during the recent series of speaker engagements that took place in the run up to the blackout period before next week’s policy meeting.

Markets appeared to have interpreted this to mean there is a rising risk the exemption will not be extended. Indeed, the view now is that it is something of a coin toss. The shift can be seen in the Treasury market as the spread between bond yields and swap rates has tightened.

The latest Fed data also revealed there was a $23.5 billion decline in holdings of bills. While these have been volatile, continued bill paydowns by the Treasury should gradually shrink this dealer inventory.

There was also an anomaly in six-to-seven year holdings, which rose slightly. This may reflect the disastrous auction during the same week, which saw dealers stuck with 39.8% of the $62 billion sale, or $24.7 billion, the largest ever nominal take-down at a seven-year offering. That said, the data doesn’t encompass the big moves in the past week, when 10-year yields climbed to levels last seen before the pandemic.

While the Fed is still holding the fate of SLR up its sleeve, “we know the trend for rates is up, and it probably isn’t over,” Stephen Innes, chief global markets strategist at Axi, wrote in a note. “That is a very uncomfortable proposition for risk markets.”

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