Treasury's Regulation Unwind Already Having An Effect on Markets

  • SLR change may free $2 trillion of bank balance sheet capacity
  • Swap spreads widen as Treasuries seen as biggest winner

The Treasury’s proposal to unleash financial sector animal spirits constrained over the last seven years by the weight of regulations is already sweeping through markets.

Just look at the ease in exchanging foreign-currency denominated loans for those in dollars, interest-rate swap spreads, and gauges of the cost to fund Treasuries through repurchase agreements.

Traders see the changes as allowing banks to move away from building huge coffers of ultra-safe debt and extend credit elsewhere in the system, as well as enabling them to beef up dealing Treasuries as funding trades become easier and cheaper. The knock-on wave to the financial sector could be in the order of $2 trillion in new liquidity, according to Deutsche Bank AG.

One-year cross currency basis swaps between dollar-yen tightened to the narrowest since 2015 this week. These agreements, an exchange of two different floating-rate payments each denominated in different currencies, have since the financial crisis been a key barometer of how difficult it is to get needed greenback funding.

In the interest-rate swaps market, where investors exchange fixed- for floating-payment streams, Treasuries have outperformed given expectations that trading in the debt will prove more liquid under a Trump Administration regulatory regime. One of the perverse consequences of post-financial crisis reform was that private borrowers could borrow more cheaply then the U.S. government. Swap spreads have started to reverse course.

“The effect of this change will be seen most in Treasuries, increasing liquidity,” said Priya Misra, head of global rate strategy at TD Securities in New York. These changes will “cut banks’ balance sheet costs.”

Treasury officials want to change the Supplementary Leverage Ratio, known as SLR, to exempt Treasuries, cash on deposit at central banks and initial margin for centrally-cleared derivatives from the denominator of the metric’s calculation. Such a move would lessen the capital hit for dealing in repurchase agreements, and free up balance sheet capacity and trading in Treasuries.

The SLR tweaks should drive Treasury repo rates down closer in line with the federal funds rate, according to Citigroup Inc. The secured borrowing agreements, which are backed by collateral, usually traded below the unsecured fed funds rate measured by overnight index swaps prior to the financial crisis. That narrowing should make it easier to financing debt holdings, which grease the wheels of bond trading.

The proposed overhaul also includes tinkering with banks’ liquidity coverage ratio, or LCR, adjusting the annual stress tests that assess whether lenders can endure economic downturns, loosening some trading rules and paring back the powers of the watchdog that polices consumer finance.

Treasury Secretary Steve Mnuchin said in a June 20 CNBC interview that he and his staff are “busy working on regulatory relief,” adding “we want to unlock billions, if not trillions, of new liquidity.”

Mnuchin’s intent to soften the LCR mandate, which would reduce banks’ demand for high-quality liquid assets, or HQLA, should lessen the incentive for banks to hold government debt versus higher-yielding assets, according to JPMorgan Chase & Co. The objective is to stimulate the flow of credit throughout the financial system.

While alterations to Dodd-Frank Act rules will require Congressional action, traders’ hopes are fueled by the fact that about 80 percent of the Treasury’s proposals -- including adjustments to the SLR -- can be enacted via agencies, primarily the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.

The SLR changes alone could free as much as $2 trillion of balance sheet capacity for banks, according to Deutsche Bank. That may be enough fuel to help spur inflation toward the Fed’s target, making it easier for policy makers when it comes to accomplishing their objective of normalizing borrowing costs almost a decade after the financial crisis.

“The Treasury’s suggestions for financial reform could constitute a catalyst for more robust growth and more rapid erosion of remaining slack in the labor market,” a team of Deutsche Bank strategists lead by Stuart Sparks wrote in note. “This could push inflation up towards target and allow the Fed ‘space’ to raise rates” faster than the market now predicts.

— With assistance by Ye Xie, and Brian Chappatta

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