By Paul J. Davies 

Treasury prices have stabilized following last month's rout, but many investors say a continued recovery likely hinges on an imminent decision on U.S. capital rules for banks.

A special exemption allowing banks to hold less capital compared with the size of their balance sheets is due to expire March 31, nearly a year after its adoption to facilitate the Federal Reserve response to the coronavirus pandemic.

The exemption enables large banks to exclude their holdings of Treasurys and central bank reserves when working out how much capital they need to meet a standard known as the Supplementary Leverage Ratio. The banks will need more capital to hit the same ratio levels if the exemption is allowed to expire, a requirement they could meet by trimming their balance sheets -- which often means selling Treasurys.

February's selloff took the yield on the 10-year Treasury note to its highest level in a year, in an investor retreat driven by expectations of stronger growth and inflation and concern about rising U.S. debt issuance. Some investors say banks selling Treasurys would stand to push yields higher still.

If capital relief is made permanent, "banks can go ahead and buy more Treasurys," said Zoltan Pozsar, money-market strategist at Credit Suisse. If not, he added, they could do the opposite.

The exemption was created to help the Fed inject vast amounts of fresh money into capital markets, giving commercial banks a dispensation for the rapid growth in their balance sheets that is a byproduct of large-scale central bank bond-buying programs.

Both Citigroup Inc. and JPMorgan Chase & Co. called for the exemption to be made permanent or at least extended in fourth-quarter calls with investors.

Fed Chairman Jerome Powell was asked several times in last week's congressional hearings whether this capital relief would be extended. He said only that the Fed was looking at it and had made no decision. Mr. Powell is due to speak Thursday at The Wall Street Journal Jobs Summit and some Fed watchers suspect he might address the exemption then.

Several senators questioning Mr. Powell on an esoteric bank capital rule shows they are getting pressure from some important constituents, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. "Should the exemption be extended it will spur demand for three-year to seven-year Treasurys especially," he added. That covers the part of the yield curve that sold off most heavily last week.

The SLR measures the total size of a bank balance sheet and sets a minimum capital requirement. For the biggest U.S. banks, capital must be equal to at least 5% of their total assets under the SLR measure. The point of this measure is to act as a backstop that guards against banks being too aggressive or making mistakes with their risk-based models for setting capital requirements.

The exemption has had a sizable impact for some banks. Citigroup's leverage ratio was 7% at the end of the fourth quarter, but dropped to 5.9% without the exemption, it told bond investors at the end of January. At JPMorgan, the effect was similar: A reported 6.9% leverage ratio was just 5.8% without the exemption, according to its earnings presentation.

Mark Mason, Citigroup's chief financial officer, said the Fed had been thoughtful about the leverage ratio exemption on the bond investor call in January. "I would hope that they'd give additional consideration around extending it or even making it permanent," he said.

The European Central Bank introduced a similar exemption to cut central bank reserves from leverage ratio measures last September that is due to run out at the end of June. There is concern among analysts that an end to the ECB's exemption could hurt activity in repo markets again because banks will likely look to shrink their balance sheets.

To be sure, the selloff in Treasury markets last week wasn't driven primarily by banks: There are other potential culprits such as a big unwinding of hedge-fund trades using borrowed money to bet on relative price moves, which Mr. LeBas for one thinks was a big contributor.

However, banks are a key source of demand for Treasurys and if the exemption ends, big banks will likely significantly reduce their buying just as issuance grows in support of the government's growing spending plans, according to Blake Gwinn, head of U.S. rates strategy at NatWest Markets.

"Banks have absorbed more than their 'fair share' of increased Treasury supply the last year, which has inarguably helped to keep yields in check," he said.

Between the end of 2019 and the third quarter of 2020, banks increased their holdings of Treasurys by more than all other types of investors apart from mutual funds and the Fed, according to data from Sifma. Banks' share of the market rose from less than 5.4% to more than 5.5% of the market.

Write to Paul J. Davies at paul.davies@wsj.com

(END) Dow Jones Newswires

March 03, 2021 06:52 ET (11:52 GMT)

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