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Fed Decision Creates Treasury Market Uncertainty

Investors could face renewed volatility after the Federal Reserve said it won’t renew a pandemic-related relief initiative for U.S. banks. How will this impact the financial system and the $21 trillion Treasury market? Our director of short duration fixed income, Peter Yi, explains.

  • The Fed’s Decision
  • Investor Reaction
  • Money Market Assets Likely to Grow

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Investors could face renewed volatility after the Federal Reserve on Friday announced that it won't renew a pandemic-related relief initiative for US banks. Ultimately, it's incentivizing them to hold less treasuries and customer deposits. How will this impact the financial system and the $21 trillion Treasury market? Let's take a look.

The Fed provided relief on the so-called SLR, or supplemental leverage ratio, a year ago to help stabilize markets as the coronavirus spread. The relief allowed banks to hold treasuries and central bank reserves without affecting the regulatory minimum level of capital, or equity, a bank must hold under the previous SLR definition. The expiration of the relief at the end of the month threatens to undermine the critical function banks play in facilitating liquidity in the financial system.

Investors will be eager to see how US banks react to the expiration. As investors weigh the impacts of the expiration of the SLR exemption, conflicting views have emerged, influencing different parts of the yield curve. Investors on the short end of the yield curve scoured the marketplace for Treasury bills with any positive yield, believing that excess liquidity in the financial system will continue to grow and overbid government securities.

Meanwhile, longer-term Treasury investors observed a modest sell-off, believing that the largest bank intermediaries may need to reposition balance sheets to avoid additional capital requirements and potentially impact market liquidity.

Investors will closely watch this week's Treasury auctions to look for signs of renewed market volatility or abnormal market functioning caused by the relief expiration. We believe the expiration of the SLR exemptions will likely put assets in motion, prompting a shift from banking deposits into asset management solutions within the $4.3 trillion money market industry.

The expected inflows into the money market industry will reinforce the expectation that cash will continue to be a good way to protect against volatility. But it comes with little return.

Peter Yi, CFA

Director, Short Duration Fixed Income and Head of Taxable Credit Research
Peter Yi is director of short duration fixed income and head of taxable credit research for Northern Trust Asset Management.