On Friday, March 19th, two days after the Fed's March FOMC meeting, what the market feared most happened.

The Fed announced that the relief to replenish the leverage ratio (SLR) would expire on March 31 as originally planned, and the easing had been widely expected to continue. The Fed plans to reassess SLR to ensure that it still works in a "high reserve" environment.

In hindsight, this "anomaly" contrary to market expectations was first seen at a press conference by Federal Reserve Chairman Colin Powell on Wednesday.

When asked whether the SLR waiver would be extended after it expires, Powell said he would not answer for the time being, because "in the next few days, we will announce the latest announcement around SLR."

At that time, some analysts pointed out that it was unusual for Powell to refuse to answer a question directly. he would generally answer some questions that he thought should not be answered in detail, but this time he directly asked the reporter to change the topic.

The Federal Reserve said on Friday that it believed that allowing the rules to expire would not weaken liquidity in the Treasury market or cause market chaos. The government bond market has stabilized, and the big banks are still well capitalised and have about $1,000bn in reserves, and the removal of SLR relief will only allow banks to fine-tune these levels. The Fed does not believe that banks need to sell Treasuries to meet reserve requirements.

What is the recent focus of financial markets, SLR?

SLR (supplementary leverage ratio) is an indicator of the Fed's capital adequacy ratio for commercial banks. The formula of SLR is tier one capital / risk assets, where tier one capital includes common stock and other tier one capital.

In the wake of the 2008 financial crisis, the Fed revised SLR rules to impose restrictions on extra leverage of large US banks to guard against systemic risks. At that time, eight systemically important banks, including JPMorgan Chase and Citigroup, were required to meet a minimum 5 per cent of SLR.

On April 1, 2020, regulators such as the Federal Reserve temporarily revised the rules to allow deposit-taking institutions not to include US Treasuries and reserves when calculating SLR, thus making it easier for them to buy US debt and significantly reduce the pressure on large US banks to assess capital adequacy indicators. The growth rate of cash assets and loans of American commercial banks increased significantly after March 2020.

Why is SLR so important?

According to the CICC fixed income study, under the impact of the epidemic last year, American companies and residents sold their assets in search of the safest cash, and bank deposits increased sharply, resulting in a significant rise in bank reserve requirements. At the same time, the Fed launched an unlimited amount of QE to inject liquidity into banks by buying large amounts of bonds, and the balance sheets of large banks expanded rapidly.

Under the condition that the first-tier capital of banks remains unchanged while reserves increase, large banks need to reduce credit, bonds, and other assets to meet the assessment requirements of SLR indicators, which reduces banks' willingness to lend, is not conducive to stimulating economic recovery from the impact of the epidemic, and leads to the deterioration of supply and demand in the US Treasury bond market.

This is the background for the Fed to take the lead in working with regulators to ease SLR requirements. This professional practice would not have attracted too much attention from the general public, but the SLR relief expires at the end of March after a surge in US bond yields triggered stock market turmoil. That's when people found outIt turns out that the most important thing about the SLR relief is that it has allowed US banks to buy large amounts of Treasuries over the past few months.

According to Bank of China research statistics, by the end of 2020, the amount of treasury bonds held by US banks reached 966.88 billion US dollars, accounting for 4.4% of the total assets of US banks in the same period, an increase of 46.9% and 1.2% respectively compared with that before the implementation of the exemption policy. Especially in the context of rising US bond yields, the US banking industry has become a rare main body to increase the share of US debt except the Federal Reserve.

However, despite Wall Street's call for an extension of SLR relief, the Fed has not made a clear statement. McWilliams, chairman of the Federal Deposit Insurance Corporation (FDIC), who is involved in deregulation, said there was no need for further deregulation of SLR, and two important Democratic senators also sent a letter to the Federal Reserve suggesting that the SLR exemption should not be extended.

What is the impact of the non-renewal of SLR relief measures on the market?

It is conceivable that if the SLR relief expires, in order to meet the capital adequacy requirements under the previous SLR review framework, large US banks need to replenish tier one capital or reduce other types of risky assets (such as US Treasuries, credit, etc.). Once banks sell Treasuries, there will be more upward pressure on yields in the face of market inflation expectations.

After the SLR relief expired, the United States happened to face the reduction of the Treasury Department's General account (TGA) in accordance with the statutory requirements. The US Treasury needs to reduce the nearly $1.4 trillion remaining in the Fed's account TGA to $133 billion before the August debt ceiling deadline.

After the expiration of SLR, when TGA shrinks and reserves rise sharply, banks will have a funding gap of about $1.6 trillion to $2 trillion, which needs to be solved by being forced to cut assets other than reserves, limit deposit expansion or increase capital. In fact, the US banking system has begun to sell Treasuries to reprice the maturity of the SLR:

So if the SLR does not extend smoothly, the long-end sell-off will continue, while the short-end interest rate will be steeper because banks restrict the expansion of deposits (increasing reserve occupation), there is pressure to push short-end interest rates to negative interest rates, resulting in a further steeper yield curve.

In addition to SLR concerns, there are comments that the bigger problem now is that the bond market is nearing a turning point. Traders will begin to realize that over the past year, more than 100 per cent of net issuance of US Treasuries has been monetized by the Fed, and hedge funds, prime brokers and commodity trading advisers are all selling, which requires central banks to intervene and support the bond market again, otherwise people will understand that there would be no more miracles without the Fed buying bonds.

How did the market react after the surprise announcement of the Federal Reserve?

Sure enough, U. S. bond yields rose again on Friday morning, and stocks were weighed down.

After the Federal Reserve announced that the SLR relief measures could not be extended before the US stock market, the yield on the 10-year Treasury note, as the anchor of asset pricing, rose 3 basis points to 1.73% in the short term, and stood at 1.75% again within 20 minutes of the opening of US stocks, erasing the intraday decline and staying at an one-year high. At one point, the yield on five-year treasury bonds rose 3.5 basis points to 0.899%, a new high this year.

At the same time, the Dow's decline widened to 1% when the 10-year Treasury yield hit 1.75%, and the previously high-opening Nasdaq fell at one point. At one point, the European Stoxx 50 stock index and key countries such as Germany, Britain and France fell more than 1 per cent.

As of press time, both the S & P 500 and the Nasdaq have risen.

Michael Schumacher, head of interest rate strategy at Wells Fargo, pointed out that the market reaction showed that people were clearly surprised because it was widely expected that even if the Fed did not continue this easing, it would give more time warning, rather than just 12 days in advance, as it does today. Banks are the larger holders of five-year Treasuries, so the yield has risen significantly.