Macroeconomics | What does the rise in US bond yields and the non-extension of the Supplementary Leverage Ratio (SLR) reveal?

The FOMC meeting concluded last week, where Federal Reserve (Fed) officials updated economic data and reiterated that they would not raise interest rates or reduce bond holdings. However, what the market is truly concerned about is that the Fed confirmed that the supplementary leverage ratio (SLR) relief extension will not be prolonged. This article will briefly summarize the FOMC meeting statement, the impact of not extending the SLR, and what the increase in U.S. bond yields really signifies.

Over the past few weeks, the rise in the U.S. ten-year bond yield has become a hot topic in the market. Most analysts believe that the increase in bond yields may lead to higher borrowing costs, posing a risk of a stock market decline.

Such concerns are understandable. The ten-year bond yield serves as a benchmark for mortgage rates, long-term corporate borrowing rates, and also indicates inflation expectations. Elevated inflation expectations can lead to concerns of an overheating economy, causing many to worry that the Fed may raise interest rates prematurely.

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However, after the FOMC (Federal Open Market Committee) meeting concluded last week, Fed Chair Jerome Powell reiterated that the quantitative easing bond purchase program remains unchanged at $120 billion per month, involving the purchase of government bonds, corporate bonds, and mortgage-backed securities (MBS). The Fed also maintained the low benchmark interest rate of 0% to 0.25% until achieving inflation expectations and full employment.

Furthermore, the Fed updated their expected economic data post-meeting.

Fed officials forecasted an upward revision of GDP growth rate to 6.5% this year; they projected that the PCE (Personal Consumption Expenditures) inflation rate would rise to 2.4% this year but drop to 2% in 2022. The year-end unemployment rate is expected to decrease to 4.5%, further dropping to 3.9% in 2022 and 3.5% in 2023, with a long-term median forecast of 4%.

The extremely accommodative policies and the conclusion of maintaining low interest rates from the FOMC meeting have certainly alleviated market concerns. Following the press conference, U.S. stocks rose, bond yields fell, and the fear index VIX declined.

However, the market has not entirely let go of its worries because Jerome Powell avoided the issue of the Supplementary Leverage Ratio (SLR) during the post-meeting press conference. Two days later (3/19), the Fed officially announced that the SLR relief would not be extended.

What problems could the SLR cause? Before answering this question, it is necessary to understand the U.S. ten-year bond yield.

Is the Rise in U.S. 10-Year Treasury Yields Really Harmful to the Economy?

Traditionally, U.S. Treasury bonds are considered safe-haven assets because they are issued by the U.S. government, with almost zero default risk, making them a "risk-free rate."

Generally, in a "normal economy," when investors perceive high risks in the stock market, they tend to shift their funds from stocks (or corporate bonds) to the bond market. This increase in demand for bonds raises bond prices, causing yields to decrease. The 10-year Treasury yield serves as a benchmark for long-term corporate borrowing rates. As a result, lower borrowing rates reduce corporate borrowing costs, helping businesses expand and promoting economic recovery.

Once the economy starts to recover, with improved corporate earnings, investor confidence increases, leading to a shift of funds from the bond market to the stock market (or corporate bonds). This causes bond prices to drop and yields to rise, which helps prevent overheating of the economy and inflation.

Graphically, the process may look like this:

High stock market risk (economic overheating) → Buy bonds → Price increases, yields decrease → Lower borrowing costs → Low rates promote business expansion → Economic recovery → Sell bonds for stocks → Price drops, yields rise → Increased borrowing costs → Prevent overheating and inflation.

Following this logic, the rise in the U.S. 10-year bond yield is actually part of the economic recovery. Although there may be signs of fund rotation, in a healthy bull market, both the U.S. stock market index and the 10-year bond yield index tend to rise. So why has this trend turned into panic?

This panic arises because, after a liquidity crisis last year, the Fed initiated a monthly $120 billion quantitative easing program to buy bonds, artificially raising the price of 10-year bonds. This action aimed to expand credit to prevent liquidity crises and to stimulate economic recovery by keeping interest rates low.

However, over the past year, growth stocks (tech stocks) benefited from low interest rates, as these companies heavily leveraged debt for investments in the environment of quantitative easing and low rates. On the other hand, traditional sectors like tourism and energy were constrained by the pandemic and couldn't expand their business operations even with low interest rates.

With the vaccine rollout and expectations of a stronger economic recovery, along with the government's forthcoming issuance of bonds (a $1.9 trillion relief package), bond prices have naturally decreased, leading to higher yields.

Therefore, in recent weeks, the decline in growth stocks can be attributed to two main reasons: investors' concerns about rising interest rates affecting the growth of these stocks, and funds rotating into sectors related to economic recovery such as tourism, energy, and finance.

In the Fed's view, as long as interest rates do not rise to a "worrying" level that could jeopardize economic recovery, the temporary correction in tech stocks is not a concern for the Fed.

With the issue of U.S. bond yields addressed, let's discuss the concern surrounding the non-extension of the SLR.

Does the Non-Extension of the SLR Affect U.S. Bond Yields?

The Supplementary Leverage Ratio (SLR) is a leverage ratio introduced by commercial banks post the 2008 financial crisis, as part of the "capital adequacy ratios."

Prior to the 2008 financial crisis, there were various capital adequacy ratios that assigned different risk weights to assets. Banks could manipulate these ratios by hiding risky assets using financial instruments to evade regulation.

After 2008, to prevent excessive leverage by banks, the Fed mandated that large U.S. banks maintain capital of at least 3% of all risk-weighted assets. Additionally, the Fed changed the regulatory approach to assign equal risk weights to all assets, whether they are reserves, Treasury bonds, loans, or other assets.

However, after the outbreak of the pandemic in March last year, quantitative easing and economic stimulus measures led to a rapid increase in bank deposits. As a result, the Fed announced a one-year relaxation of the SLR requirement, excluding Treasury bonds and reserves from the SLR calculation. This move was intended to allow banks to expand lending, injecting funds into businesses or individuals.

Is this relaxation really that severe?

Following the Fed's announcement of non-extension, many are concerned that banks may have to sell Treasury bonds to comply with the SLR, causing 10-year Treasury yields to rise again or leading to banks no longer accepting customer deposits.

But is this really the case?

In a piece titled "Misinterpreting the Cause and Effect of the SLR by the Public," Yu Zhean, President of Humble Investment Society, stated:

The expiration of SLR exemptions has no substantial impact on driving up Treasury bond yields.

The article points out that 90% of global systemically important banks (G-SIBs) hold exempted Treasury bonds and reserves in their banking book portfolios, while only 10% are in their trading book inventories.

Moreover, since SLR exemptions are voluntary and come with many conditions, many banks have actually not participated to avoid constraints from banking regulators.

Yu Zhean also noted in the article that the SLR ratios of the eight major banks are above the Fed's minimum requirement of 6%, indicating that there will be no selling pressure on Treasury bonds in the banking book portfolios due to the expiration of SLR exemptions.

Furthermore, even at the financial holding company level, the SLR ratios, calculated using the original SLR proportion, are well above the 5% minimum standard, indicating that there will be no selling pressure on Treasury bonds in the financial holding company portfolios due to the expiration of SLR exemptions.

From these facts and charts, it is evident that the non-extension of the SLR will not affect U.S. 10-year Treasury bond yields, which explains why the Fed chose not to extend it. However, with the $1.9 trillion relief package looming, to prevent a large influx of deposits affecting overnight repo rates, the Fed has raised the daily limit in the overnight reverse repo market from $300 billion to $800 billion.

Yu Zhean believes that the market's confusion between the non-extension of SLR exemptions and the increase in the reverse repo market limit is somewhat "unfounded."

If the Fed were truly concerned about selling pressure on Treasury bonds, they would introduce repurchase agreements (RP) instead of reverse repurchase agreements (RRP). RPs are the means by which central banks absorb bonds from the market, while RRPs are the means by which central banks absorb reserves from the market, indicating a release of Treasury assets from the balance sheet.

If the market is already experiencing selling pressure, the Federal Reserve increasing the reverse repo limit only adds fuel to the fire of Treasury bond selling pressure.