Treasury Market’s Emergency Support Is Poised to Vanish Soon

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The Federal Reserve looks poised to disappoint Wall Street by not extending an emergency exemption that’s propped up the Treasury market since last year’s pandemic panic.

After bond market liquidity dramatically disappeared a year ago, the Fed let banks stop factoring in Treasuries to their so-called supplemental liquidity ratios -- letting them stockpile U.S. debt without breaking regulations. That exemption expires March 31, and central bankers have given no indication it’ll get authorized for longer.

The impending expiration, some say, is a reason why Treasuries just suddenly got so volatile. Disorderly trading provides a justification for regulators to keep the SLR exemption, Bank of America strategists Ralph Axel and Mark Cabana wrote in Friday note. They don’t expect an extension, but said there’s some alternatives that could help.

“Extending SLR carve outs may offer a more palatable option vs more extreme control measures such as a twist,” they wrote. Cabana had argued earlier in the week that the Fed may revive Operation Twist -- simultaneously selling short-term paper while buying longer-term Treasuries -- which would help lift rates at the short-end and stabilize yields at the long end.

The end of the regulatory carve-outs comes at a tenuous time as interest-rate markets have only grown more volatile, with 10- and 30-year Treasury yields climbing to their highest levels in more than a year. Without the exemption, there may be a “knee-jerk reaction” of tightening in the market for swap spreads, particularly the belly of the curve, the Bank of America strategists said. There’s also a risk of increased funding pressure at year-end as institutions become more capital-constrained.

Long-end dollar swap spreads, the difference between Treasury yields and interest-rate swaps, continued to narrow Friday with the 10-year tenor approaching levels seen in the Treasury selloff a week ago. The bulk of tightening came after Federal Deposit Insurance Corp. Chair Jelena McWilliams said it doesn’t seem as though banking agencies need to extend the emergency measure.

In the likely case that the exemption goes away later this month, the Bank of America report offered two options that would at least offer some partial relief until there’s a longer-term solution. The first is to allow for cash and Treasuries accumulated during the pandemic to be exempted from bank balance sheets since it would address a specific period of time. The other would be to exempt only reserves and not Treasuries from the SLR rule, though they think this is less likely because it would interfere with banks’ role as the “repo police,” investing cash in the repo market when the rate trades above the Fed’s interest on excess reserves rate of 0.10%.

In the minutes from the February Treasury Borrowing Advisory Committee meeting, Deputy Director Nick Steele said some dealers noted that the SLR exemption was initially helpful but that waned because everyone knew it was a temporary situation and also the exemption didn’t include repurchase agreements.

A longer-term solution for the inner workings of the Treasury market is needed, the Bank of America strategists said.

“The current carve-outs are an insufficient solution to a more complex and longer lasting problem of a growing Federal Reserve balance sheet and Treasury debt market,” Axel and Cabana wrote.

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