Monday Musings: March 22, 2021

Mar 22, 2021

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Public Trust Credit Team
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Supplementary leverage ratio exemptions set to expire at month-end

Last Friday, the Federal Reserve announced that it will not extend capital relief granted to bank holding companies at the onset of the pandemic in relation to the supplementary leverage ratio (SLR). On April 1, 2020, the Fed created an exemption within the SLR framework that allowed banks to exclude Treasuries and Fed reserves from the calculation of the ratio, essentially relaxing the amount of capital that banks had to maintain against Treasuries and deposits and, in turn, lowering the overall capital requirements for the financial sector. But that exemption is now officially set to expire at the end of this month on March 31. In light of the Fed’s decision not to extend the capital relief, banks will either be forced to hold additional capital or reduce their Treasury holdings – more likely, a combination of both. 
 
According to Morgan Stanley, the expiration of the SLR calculation exemption will have a more pronounced impact on JP Morgan, Citigroup, Goldman Sachs, and Bank of America but will not leave their SLRs in jeopardy of breaching the regulatory threshold. In order to ensure that they are able to meet their SLR requirements, banks have a few options; they can turn down deposits which will lower their reserve requirements, reduce the amount of share buybacks, sell Treasuries, or issue additional preferred stock. Following Friday’s announcement, Fed officials stated that the banking sector remains extremely well-capitalized and that they do not believe the largest banks will need to sell large blocks of Treasuries to meet their requirements.

The Fed’s stance at Wednesday’s meeting creates an opportunity for IG spreads to widen this year

During the Fed’s meeting last week, the Board increased their expectations of growth, unemployment, and inflation, signaling the economy is on solid footing. In particular, the Fed’s plan to allow inflation to run above 2% was a meaningful takeaway though Powell’s dovish comments on rate increases and bond-buying showed the Fed is not ready to move any time soon. According to research from Bank of America, the Fed’s less hawkish tone and emphasis on data could end up making a case for IG spreads to widen this year. Most analysts expect economic data to continue surprising to the upside, creating the case for the Fed to start raising rates earlier which would harm IG bond prices. Coupled with low investor demand caused by tight spreads, this sets up a spread widening scenario in the IG market. Overall, this continues to support our thesis that finding value in investment-grade credit will be a challenge in 2021.

Follow-up on last Monday's Tri-Party General Collateral Rate musing

The many devoted readers of the Public Trust Monday Musings have been clamoring for additional details on the Tri-Party General Collateral Rate (TGCR) piece included in the last Monday Musings. The piece offered some color on the slightly negative first percentile TGCR reading on Friday, March 12. After publishing, we learned that BNY Mellon (the clearing house for 80% of tri-party repo transactions) is in the final stages of testing negative rates that were previously supposed to be operationally impossible for BNY Mellon to process. It appears that the operational hurdles have been lifted, so negative rates could creep into other reported transactions. However, the Fed’s overnight reverse repo will remain the desired funding mechanism when repo rates fall below five basis points. Because of this, we continue to believe that repo rates will not turn negative for any large segment of the market or for any meaningful length of time.
All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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