Could bank deregulation explain resilience in US Treasuries?

In a week when US core consumer price inflation unexpectedly rose to 0.4% month-on-month and Federal Reserve (Fed) chair Jerome Powell told Congress the central bank was in “no hurry” to cut interest rates, many market participants have been surprised by the relatively muted reaction in US Treasuries (USTs).

Bellwether 10-year UST yields did jump by around 10bp following Wednesday’s inflation print, but they have since settled back down to their pre-print level of around 4.55%.

One explanation for this could be the anticipation of looser banking regulation under the Trump administration, which is likely to increase the incentive for US banks to buy and hold USTs.

Back in November we wrote a blog about the significance of negative swap spreads, which turned out to be one of our most-read pieces of the year.

As a reminder, the longstanding trend towards negative swap spreads across major currencies has been widely attributed to two things. The first is greater supply of government bonds thanks to quantitative tightening. The second is stricter banking regulation, and in particular the introduction of bank leverage ratios, which require banks to hold a minimum level of capital against their total balance sheet exposure (including government bonds). Both these factors effectively weaken demand for government bonds such as USTs, putting upward pressure on yields.

The reason we are writing about swap spreads again now is that the US swap spread has become considerably less negative year-to-date (see Exhibit 1), a move which can be linked directly to the building expectation of banking deregulation.

At this stage we do not know the precise details of the deregulation plans, but one widely discussed proposal has been to exempt UST holdings and deposits held at the Fed from the calculation of US banks’ supplementary leverage ratios (SLR). Banks have long argued that having to hold capital against risk-free USTs is overly restrictive, and their lack of incentive to buy, hold and trade them has also been blamed for poor liquidity in the UST market (USTs were temporarily excluded from SLR calculations between 1 April 2020 and 31 March 2021 as an emergency measure to boost liquidity during the Covid-19 crisis).

At a conference in Kansas on February 5, Fed board member Michelle Bowman said the recent relative illiquidity in the UST market could be partially attributed to the increase in leverage-based capital requirements. Powell also backed the SLR exemption in his testimony to Congress this week, saying he wanted to “get it done”.

Bowman’s comments in particular were the trigger for the shift shown in the chart above, with the US 10-year swap spread having moved from -46bp before February 5 to around -37bp now. That level is still well off the -20bp we saw during the temporary UST exclusion in 2020-21, so there is clear potential for this to move further as we get more clarity around the final shape of the rules. It is worth saying the final changes may not come before 2026, but as usual they are likely to influence bank behaviour well before they are implemented.

So, as we asked back in November, why should bond investors care about this?

Deeply negative swap spreads in our view have certainly contributed to greater volatility in government bonds, since the levels were not only influenced by underlying future interest rate considerations, but also supply and demand dynamics for the bonds. Narrowing (or more negative) swap spreads have also contributed to higher funding costs for the affected sovereigns, as they translate to higher coupons further along the maturity curve. In the euro market specifically, the narrowing of swap spreads has led to temporary constraints in the funding market for some debt instruments.

Lower capital charges against USTs would create a strong incentive for banks to engage in the trade as long as swap spreads remain in negative territory. Essentially, a bank “should” be interested in a trade that involves borrowing from the Fed at the current Fed Funds rate of 4.33%, buying 10-year USTs at 4.55%, and then at the same time engaging in a swap trade where they pay away at a fixed rate of 4.15% and receive a floating rate close to the 4.33% they borrowed at. In theory, they can pocket the difference between 4.55% and 4.15%.

In practice there are transaction costs involved here and other capital considerations regarding USTs, such as market risk, but the crucial point is that currently there is a capital constraint associated with the SLR ratios that limits banks’ appetite to engage in the UST trade, unless the spread is sufficiently negative to meet their return-on-equity (ROE) threshold. If this charge was reduced or eliminated altogether, that ROE consideration would be reduced and banks would be less sensitive to the level of the swap spread, which would likely see the difference between the 10-year UST yield and the 10-year swap rate (i.e. the swap spread) compress.

With banks providing a wider buyer base for USTs, this could help limit to some extent the rates volatility we have experienced in recent months.