How the Fed’s SLR Tweak Could End the Bond Bear | Bonds & Fixed Income

On June twenty fifth, the Federal Reserve quietly introduced a important change to the Supplementary Leverage Ratio (SLR). While the headlines have been muted, the implications for the U.S. Treasury market have been something however.

For subtle traders, this technical shift marks a refined however highly effective pivot in financial mechanics. It may create demand for Treasuries, improve market liquidity, and push yields decrease at a time when the economic system is slowing. As proven in the Economic Output Composite Index (EOCI), which includes almost 100 knowledge factors, latest experiences counsel the economic system is weaker than headlines suggest. The identical is confirmed by the 6-month fee of change in the Leading Economic Index, which stays in contractionary territory.

Historically, such readings have coincided with financial recessions. However, this has not been the case since 2022 due to the huge quantities of financial stimulus which have saved the economic system growing. That help is shortly fading, probably placing the main banks at risk, which brings us to the SLR.

Understanding the SLR and Why It Matters

The Supplementary Leverage Ratio was initially carried out as a post-GFC (Global Financial Crisis) safeguard. The concept was easy: restrict the quantity of leverage banks may tackle by tying it to their capital base, regardless of the riskiness of the belongings. That meant a Treasury bond and a junk loan have been handled equally for leverage functions. Unsurprisingly, the rule disincentivized the main Wall Street banks from holding low-risk belongings like U.S. Treasuries, significantly in durations of stability sheet stress, in exchange for money owed with greater yields.

In a welcome reversal, the Fed introduced on June twenty fifth that it, the FDIC, and the OCC are easing that constraint by recalibrating the SLR to mirror a more nuanced risk-based strategy. Specifically, the new rule adjusts the enhanced SLR (eSLR) add-on to 50% of the Method 1 Global Systemically Important Bank (G-SIB) surcharge, harmonizing it more carefully with worldwide requirements. This reduces the leverage burden throughout the largest U.S. banks and opens up substantial stability sheet capability.

What does this imply in observe? According to Goldman Sachs’ Richard Ramsden, the proposed modifications may unlock between $5.5 and $7.2 trillion in bank stability sheet capability.

To put that quantity into perspective, the increase in stability sheet capability for the banks is equal to roughly 25% of GDP.

Unsurprisingly, the Federal Reserve’s member banks, JP Morgan, Bank of America (NYSE:), Wells Fargo (NYSE:), and Citigroup, stand to benefit the most. Most importantly, this opens the door for elevated repo financing and direct Treasury purchases, significantly during durations of market dislocation.

While repo and Treasury investments offer modest returns, their low-risk nature makes them splendid candidates for bolstering liquidity and assembly capital necessities. Banks can pivot towards these safer belongings in an surroundings the place credit spreads are tight and loan demand stays unsure with out incurring regulatory penalties.

SLR Implications for the Treasury Market

So, what does the SLR must do with the bond market? We mentioned this just lately in our Daily Market Commentary when this rule change was first talked about. To wit:

“Yes, I believe we will. I have, for a long time, like others, been somewhat concerned about the levels of liquidity in the Treasury market. The amount of Treasuries has grown much faster than the intermediation capacity has grown, and one obvious thing to do is to lower, is to reduce the effective supplementary leverage ratio, the bindingness of it. So that’s something I do expect we will return to and work on with our new colleagues at the other agencies, and get done.” – Fed Chairman, Jerome Powell.

Following the 2020 COVID pandemic, bonds have been in a bear market as yields have risen with inflationary pressures and elevated Fed funds charges. That yield rise was additionally compounded by elevated Treasury debt issuance lately to fund the huge stimulus and spending applications during the Biden Administration. However, the largest Wall Street banks have been reluctant to step in as a consequence of regulatory capital constraints. That reluctance retains yields greater, significantly at the long finish of the curve.

With the SLR reform, banks can deploy extra capital into Treasuries with out working afoul of leverage guidelines. This newfound demand may take up a significant portion of web new issuance. The consequence? A downward stress on yields, significantly during market volatility when banks usually pull back. In impact, this reform may clean Treasury market functioning and scale back the risk of one other episode like the September 2019 repo blow-up or the March 2020 liquidity disaster.

Furthermore, one other underappreciated impression of the SLR change is its impact on the Total Loss Absorbing Capital (TLAC) and Long-Term Debt (LTD) necessities. These guidelines, supposed to make sure that giant banks may be wound down in an orderly fashion, additionally tie into leverage ratios.

Under the new proposal, TLAC and LTD necessities can be lowered by ~5% and ~16% respectively, liberating up roughly $95 billion in wholesale debt throughout the 5 largest U.S. banks. In a rising fee surroundings, that’s not simply regulatory reduction—it’s a cost-saving measure. Lower funding prices will circulation by way of to margins, offering but another excuse for banks to reallocate capital into U.S. Treasuries and repo financing.

Portfolio Strategy: What Investors Should Do Now

From a portfolio management perspective, this shift is one other reminder that the regulatory construction issues as a lot as financial coverage.

While most traders deal with the Fed’s rate of interest selections, regulatory plumbing like the SLR performs a important position in shaping asset flows, risk preferences, and liquidity situations. With banks now more likely to increase Treasury holdings, traders ought to put together for downward stress on long-term yields, particularly during risk-off durations when the bid for security intensifies.

The substantial short place in opposition to US Treasury bonds may amplify the downward stress if an occasion forces a fast unwind. As we mentioned beforehand:

“Short positions in TLT, the popular 20-year US Treasury Bond ETF, have spiked to over 130 million shares, up from 107 million last month. TLT has 541 million shares outstanding. Consequently, the short interest has risen from 20% to 24% of the float. Furthermore, TLT’s days to cover ratio (short position/average trading volume) is nearly 3.5 days. As the graph below shows, that is far and away the most prominent short position in the ETF in at least the last 15 years.”

This doesn’t essentially guarantee a bond rally, nevertheless it considerably tilts the risk-reward back in favor of period, significantly in high-quality fixed income. For equity markets, decrease long-term yields are a blended bag. Lower yields are traditionally bullish for growth stocks, UNLESS yields are dropping quickly as a consequence of slowing financial momentum or recession risk.

Portfolio construction ought to all the time stay anchored in risk management, and the risk of being short Treasury bonds is clearly on the rise.

Bottom Line

The Fed’s proposed SLR reforms are usually not simply regulatory housekeeping—they’re a focused effort to shore up the financial plumbing of the Treasury and repo markets. The Fed is engineering a quiet however significant increase to Treasury demand by giving banks more flexibility to carry protected belongings.

For traders, meaning higher liquidity, decrease yields, and maybe a more secure financial system, as long as the unintended penalties keep in verify.

As we’ve stated earlier than, the satan is all the time in the particulars. And generally, these particulars make all the distinction.