We are on the other side of what we all braced ourselves for: the anticipated sell-off from Jerome Powell’s FOMC speech. That dip didn’t happen immediately.
Instead, fears re: J. Powell’s (aka J Pow) failure to address/comment on the Supplementary Leverage Ratio (SLR’s) started to take hold. And while Powell hinted a decision on SLR was coming soon, investors understandably, expressed themselves in a post-speech market freak out.
The Fed Chair continues to press a dovish agenda for the Fed but markets are not buying as rates run higher.
The Fed’s direction on SLR’s will impact financials and yields. At risk is some near-term financial instability. This could drive the short end of the curve higher due to liquidity issues.
Financials would see volatility in this scenario.
Advisors in Focus take a closer look at the decision around the SLR and how it can impact financials. We will discuss what the SLR measures and how it can impact financial plumbing.
Trackstar data confirms advisors interest in financials as the SPDR Financial Sector ETF (XLF) remains a top search by advisors. We understand many of our readers have exposure to the sector and want to make sure you are aware of the potential implications of the SLR decision.
Here is why the SLR is so important to the XLF?
The Supplementary Leverage Ratio (“SLR”) is the ultimate measure of capital adequacy. The SLR measures in percentage terms a bank’s ability to take losses on assets. It calculates the amount of common equity capital they must hold relative to their total leverage exposure.
- The formula is SLR = Tier 1 Capital/Total Leverage exposure.
A higher liquid asset ratio reflects a higher probability that the company will be able to pay down debt.
Cash assets are the denominator of the SLR calculation. Cash assets consist of cash and items readily convertible to cash such as treasury bills, money market funds, commercial paper, and deposits. Instruments vital to financial plumbing.
The SLR requires banks to hold a 3% leverage and institutions with more than $250 billion of assets maintain an extra 2% cushion (5% total) of high-quality capital against total assets.
Banks impacted by SLR buffer include J.P. Morgan (JPM), Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), Morgan Stanley (MS), and Goldman Sachs (GS). These institutions make up 33% of the XLF.
Here are some highlights from ETF searches this week –
|Rank||TOP ETFs BY ALL FAs (Total Traffic) Last Week||Ticker||TOP ETFs BY FAs w/ AUM >$1 bln (Total Traffic) Last Week||Ticker||TOP ETFs BY RETAIL (Total Traffic) Last Week||Ticker|
|1||SPDR S&P 500 ETF||SPY||VanEck Vectors Gold Miners ETF||GDX||SPDR S&P 500 ETF||SPY|
|2||Invesco QQQ||QQQ||SPDR S&P 500 ETF||SPY||Invesco QQQ||QQQ|
|3||First Trust Health Care AlphaDEX Fund||FXH||Smallcap ETF Vanguard||VB||ARK Innovation ETF||ARKK|
|4||ARK Innovation ETF||ARKK||US Aggregate Bond Ishares Core ETF||AGG||ProShares Ultra VIX Short-Term Futures||UVXY|
|5||First Trust Amex Biotechnology Index||FBT||Direxion Daily Financial Bull 3X Shares||FAS||ProShares UltraPro QQQ||TQQQ|
|6||Vanguard Emerging Markets Government Bond ETF||VWOB||Direxion Daily Regional Banks Bull 3X Shares||DPST||MicroSectors FANG+? Index 3X Inverse Leveraged ETN||FNGU|
|7||ProShares UltraPro QQQ||TQQQ||Invesco QQQ||QQQ||ARK Fintech Innovation ETF||ARKF|
|8||ProShares Ultra VIX Short-Term Futures||UVXY||Financial Bull 3X Direxion||FAS||Direxion Daily Semiconductor Bull 3x Shares||SOXL|
|9||VanEck Vectors Gold Miners ETF||GDX||Vanguard Small Cap ETF||VB||Technology Select Sector SPDR Fund||XLK|
|10||Roundhill Sports Betting & iGaming ETF||BETZ||iShares Select Dividend ETF||DVY||iShares Russell 2000 ETF||IWM|
|11||iShares Silver Trust||SLV||iShares Core U.S. Aggregate Bond ETF||AGG||Energy Select Sector SPDR Fund||XLE|
|12||iShares Edge MSCI USA Momentum Factor ETF||MTUM||S&P 500 Financials Sector SPDR||XLF||U.S. Global Jets ETF||JETS|
|13||Invesco Dynamic Leisure and Entertainment ETF||PEJ||MicroSectors FANG+ Index 3X Inverse Leveraged ETN||FNGU||iShares Silver Trust||SLV|
|14||U.S. Global Jets ETF||JETS||iShares MSCI Pacific ex Japan ETF||EPP||SPDR Gold Trust||GLD|
|15||ARK Fintech Innovation ETF||ARKF||iShares Silver Trust||SLV||ARK Genomic Revolution ETF||ARKG|
|16||First Trust Capital Strength ETF||FTCS||Pacific Ex Japan Ishares MSCI ETF||EPP||VanEck Vectors Semiconductor ETF||SMH|
|17||VanEck Vectors Gaming ETF||BJK||Microsectors Fang+ 3X ETN||FNGU||iShares 20+ Year Treasury Bond ETF||TLT|
|18||Financial Select Sector SPDR Fund||XLF||SPDR Dow Jones Industrial Average ETF||DIA|
|19||Energy Select Sector SPDR Fund||XLE||Financial Select Sector SPDR Fund||XLF|
|20||Direxion Daily S&P Oil & Gas Exploration & Production Bear 2x Shares||DRIP||ARK Web x.0 ETF||ARKW|
What is up with the Fed?
In early 2020, regulators noticed deposits started to rise. People hoarded cash as uncertainty around the pandemic increased. This pressured banks SLR levels and threatened to impact financial conditions.
On April 1, 2020 the Federal Reserve announced it would exempt U.S. banks treasury holdings and deposits at the Fed from the SLR for one year.
This would prevent the denominator in the SLR equation (total leverage exposure) from far exceeding the numerator (tier 1 capital) and therefore the ratio from falling too fast. The changes the Fed made reduces the denominator of this formula and, as a result, increases banks’ SLR.
The move settled financial conditions as the virus spread across the globe. Fed members must decide by March 31 to extend this exemption.
And if the Fed does not extend?
If the Fed does not extend the SLR, it will impact an already stressed bond market.
Banks will be forced to raise the level of capital held against their treasury bonds and deposits at the Federal Reserve. They would turn away deposits and refrain from treasury purchases at a time when there is nearly $2 trillion of issuance coming with the fiscal stimulus. Firms could potentially issue debt or preferred shares.
This temporarily decreases market liquidity and lowers the demand for U.S. government debt. Analysts believe that could push rates over 2%. That would inflict pain on equities.
Investors started to price in the possibility the exemption will not be extended.
The Fed could fix the issue by excluding cash and treasuries from the SLR calculation which makes the denominator lower and SLR higher.
Why does it matter to banks?
No SLR relief means banks must turn away deposits. Primary Dealers can not buy U.S. Treasuries because there is no room on the balance sheet. Banks could dump as much as $650 billion of U.S. Treasuries.
Firms would reduce lending in the repurchase agreement market. This is used by investors to finance purchases of bonds. This dries up another area of demand, pushing yields higher.
It impacts lending as the exemption reduces the amount of capital banks hold against treasuries and deposits.
Just to give you an example, Bloomberg reported that deposits increased 22% while loans were up 3%. This floods the denominator and impacts SLR.
Capital returns allow financial institutions to attract capital. An inability to provide returns will lead investors elsewhere.
The other aspect is the disruption in the short-term lending markets. This could push rates at the short end of the curve higher as counterparty risk increases. Banks profitability could be hit.
Banks thrive in a rising rate environment. However, an increase in rates needs to come from stability and growth, not dysfunction in financial markets. That increases risk and raises questions about credit quality.
The impact would put the recent rally in financials at risk.
The impact on tech?
U.S. Banks become net sellers of Treasuries. This pressures yields. The rise in yields would put more pressure on long-duration equities like the Nasdaq.
Tech long-term earnings power becomes more valuable when discounted at lower interest rates. This makes long-duration assets sensitive to changes in interest rates.
What to expect
We believe the Fed will announce an extension to the exemption. Powell and Company want to convince the markets that the rise in inflation is transitory. This suggests the rise in yields will settle once prices stabilize.
They do not need to raise the degree of difficulty by allowing financial markets to lose functionality. Banks will survive if the SLR is reinstated. This is not a panic piece. But the near-term instability would roil markets.
We will continue to follow this story.
Five Questions Advisors may see from clients:
- How does the SLR impact financials?
- Why would a bank turn away deposits?
- What function do banks play in treasury markets?
- Are all rate increases positive for banks?
- Would a pullback in banks offer a buying opportunity?