Treasury yields remain volatile after Fed scraps capital relief

Yields had fallen to 1.671% during Asian and European trading hours as overseas investors bought Treasuries after Thursday’s selloff sent the yield on the 10-year note to its highest close since January 2020. Yields fall when prices rise. But the Fed’s announcement sent the yield as high as 1.748% before paring gains to settle at 1.729%, little change from Thursday’s close, according to Tradeweb.

Stocks of financial companies were among the worst performing sectors in the S&P 500, losing 1.2%.

The Fed introduced capital relief last year to help flood the financial system with liquidity at a time when investors and businesses had been spooked by the Covid-19 outbreak and the economic shutdowns that caused it. resulted.

The relief allowed banks to exclude treasury bills and central bank deposits when measuring the size of their balance sheets against the amount of capital they hold for a yardstick known as the ratio. extra leverage (SLR). The relief meant they could quickly increase their holdings of Treasuries and reserves without needing more capital as the Fed pumped money into struggling financial markets.

Guy LeBas, chief fixed income strategist at Janney Montgomery Scott, said there’s likely been some selling of Treasuries by some banks in recent weeks as they prepare for the end of the exemption. . Friday’s news, however, was probably more important on a psychological level than in terms of new selling pressure.

“Market attention has focused on this otherwise esoteric issue over the past few weeks,” he said. “It gave her more psychological significance than she deserves.”

The end of the relief could lead to further selling by some large banks such as

JPMorgan Chase

JPM -3.23%

& Co.,

Bank of America Corp.

BAC -3.07%

or

Citigroup Inc.,

VS -2.63%

according to Daniel Belton, strategist at the Bank of Montreal. This month Mr Belton predicted that up to $200 billion in Treasuries could be sold by the banks as a group in the coming months if the exemption is reversed.

“This is still how we think of the overall selling pressure on Treasuries, although this has been increasingly priced in over the past few weeks, it is likely that some of this selling has already happened,” Belton said.

The SLR measures the total size of a bank’s balance sheet and sets a minimum capital requirement. For the largest US banks, capital must be at least 5% of total assets. This measure of leverage is a safety net designed to prevent banks from being too aggressive or making mistakes with their risk-based models for setting capital requirements.

The effect of the relief has been significant for some banks. Citigroup’s leverage ratio was 7% at the end of the fourth quarter, but fell to 5.9% without the exemption, he told bond investors in late January. At JPMorgan, a reported leverage ratio of 6.9% was 5.8% without the exemption, according to its earnings presentation.

And banks expanded their balance sheets significantly last year. Mr Belton estimated that the six largest US banks alone added $715 billion in central bank reserves in 2020 and $278 billion in Treasury bills. Banks would only seek to sell Treasuries if they wanted to get back to their higher leverage ratios quickly, Belton said.

Others think investors overreacted to the potential end of relief. Zoltan Pozsar, money market strategist at Credit Suisse, said investors were wrong to assume the special exemption was the glue that held markets together and that its end meant big US banks would have to sell Treasuries.

“Neither the Fed nor the market should fear chaos if the exemption expires,” Pozsar said.

Mr Pozsar thinks it is more likely that banks will look for ways to divert large deposits from some customers and so reduce their own holdings of central bank reserves if they want to increase their leverage ratios.

The Fed said on Friday it may need to redesign the SLR due to growth in reserves and Treasury issuance over the past year. With more debt likely to be issued to fund growing government spending and the Treasury already sending $1,400 checks to people’s bank accounts, growth in both is expected to continue.

Barclays analysts say the signal from the Fed that it might create some form of permanent SLR relief is far more important than the end of the exemption. “Permanent SLR relief could create substantial appetite for the addition of lower risk-weighted assets such as US Treasuries and agency mortgage-backed securities even as reserves rise,” they said. they write Friday to their customers.

They added that banks may have the capacity to buy more than $1 trillion in liquid securities, with a focus on medium-term Treasury bills.

Write to Paul J. Davies at paul.davies@wsj.com and Julia-Ambra Verlaine at Julia.Verlaine@wsj.com