Markets Start to Worry About Year-End After Fed Ditches Crisis Measure

The Federal Reserve’s decision to allow a regulatory exemption for banks to lapse at the end of March has led to a jump in year-end funding premiums.

December Eurodollar contracts -- which are priced off interbank rates -- have come under persistent selling pressure since the central bank said Friday that relief for banks under the supplementary leverage ratio would expire March 31, as planned. Traders are preparing for greater frictions in dollar borrowing markets now that lenders are expected to be more conservative in managing their balance sheets.

Markets Start to Worry About Year-End After Fed Ditches Crisis Measure

The frictions are mainly manifesting themselves over year-end, a period when regulatory scoring often leads banks to scale back lending. An increasing premium can be seen in December pricing of a key gauge of banking sector risk known as FRA/OIS -- the spread between Eurodollar futures and the fed funds rate -- which has widened two basis points since the Fed’s announcement. The gap is now seven basis points greater than the FRA/OIS spread for the September contract, which doesn’t cover year-end.

“It’s probably too soon,” said Rishi Mishra, an analyst at Futures First. “But then it’s also more apparent to everyone that we are going to have constrained banks this year end.”

The Fed introduced the SLR relief for banks last year as it sought to support the economy amid the coronavirus pandemic. Under the exemption, it allowed banks to hold extra Treasuries and deposits without setting aside capital for potential losses.

The direct implication of letting the relief expire is tighter bank-level controls over leverage capital, which will create more frictions in over-the-counter derivative markets, Henry St John, a fixed-income strategist at JPMorgan Chase & Co., wrote in a note.

As allocations of capital get stricter, there will be more bouts of volatility in leverage-intensive markets such as foreign-exchange swaps, he said.

End of Fed’s Regulatory Relief Creates Long-Term Market Concerns

The Fed’s announcement has also led to a widening in yen-dollar three-month cross-currency basis -- a measure of the cost to access U.S. currency. While the spot rate is around negative eight basis points, the December starting contract -- which covers year-end -- has widened three basis points since Thursday and is now around minus 41 basis points, according to data from Martin Brokers in London. A widening basis indicates a higher premium to hold dollars.

While the Fed allowed the current SLR exemption to lapse, the central bank also said it is seeking comment on further adjustments. This has given markets some optimism that a more permanent solution for the policy will be forthcoming, though the timing of the proposal may be dictated by how quickly the rules start to constrain the markets.

This is primarily a financing story, said Michael Cloherty, head of U.S. rates strategy at UBS Group AG, in a note. “Banks are still likely to buy Treasuries as substitutes for reserves.”

©2021 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.