Fed Walking A Very Tightrope

If there is no SLR (supplementary leverage ratio) extension, it is possible the 10-year quickly rallies toward two percent. Last April – post-Covid – US regulators eased SLR requirements, which were put in place in the wake of the great financial crisis. Banks were required to have equity capital equal to three to five percent of their assets back then. Last year’s exemption allowed them to exclude US treasuries and cash kept in reserve at the Fed from their assets when calculating the ratio.

If the exemption is not extended, banks likely will try to reduce their Treasury holdings, although it is also possible that, sensing the regulators were not going to extend the exemption, banks have been liquidating at least some of their holdings, putting upward pressure on the rates.

Long rates have trended higher despite an aggressive accumulation of these securities by the Fed, which has been spending up to $120 billion/month in mortgage-backed securities and treasury notes and bonds.

By February, the Fed held $4.12 trillion in treasury notes and bonds, up from $2.17 trillion last March and up to $71.2 billion from January. The problem is, there is a wide gap between what it buys and what the Treasury issues. Except for last April and May, this supply-demand discrepancy is evident in Chart 3. In February, for example, the issuance of treasury notes and bonds was $204.3 billion.

This is coming at a time when foreigners are massively liquidating their holdings of these securities. In the past, their purchases – or a lack thereof – went toe to toe with treasury issuance. But this relationship broke down in the early months of 2019.

In fact, the divergence has picked up steam. In the 12 months to February, issuance was $1.93 trillion. But foreigners continue to go the other way, with net selling of $616.4 billion in the 12 months to January (Chart 4). Both are in record territory.

Either way, we look at it, the Fed is between a rock and a hard place. It has expanded its balance sheet in such a way that normalizing it – if ever – potentially causes a negative shock across assets.

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