Bank demand for Treasuries in focus after Fed ends regulatory break

March 19 (Reuters) - Investors will be closely watching demand for U.S. government securities in the coming months after the Federal Reserve declined to extend pandemic-related regulatory relief for big U.S. banks, which means they may need to raise capital against holdings of U.S. Treasuries and central bank deposits.

The Fed said it would launch a review of the capital rule, known as the “supplementary leverage ratio,” while letting the exemption given last year expire on March 31.

Some analysts and investors are concerned that banks may need to pare bond purchases, sell assets and/or reduce lending in overnight funding markets backed by Treasuries as unprecedented growth in reserves threatens to push some banks close to their capital ratio limits.

If that occurs, it could add more pressure to a market that has already seen a sharp rise in interest rates amid a selloff spurred by expectations of a faster economic recovery and rising inflation.

“It’s possible that banks will not be able to backstop markets when they most need to during periods of extreme volatility. And that’s the big concern, that the volatile times can become more volatile,” said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York.

Benchmark 10-year Treasury yields jumped around 5 basis points on the announcement to 1.750%, nearing the one-year high of 1.754% reached on Thursday. They were last 1.716%.

Reaction was likely capped because market participants had already prepared for the likelihood that the exemption would not be extended.

“It was a marginal risk that was priced in. It was one of the reasons that 10-year yields got as high as 1.75% yesterday,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets in New York.

Banks so far have not taken advantage of the exemption, which analysts say is due to it having too many restrictions. Having it as a fallback, however, has provided some psychological support to the market.

“It’s kind of a backstop...if there becomes liquidity issues in the market the banks will have the ability to step in and buy the market, and to add more liquidity if they do start pushing up against their limits,” said Patrick Leary, chief market strategist and senior trader at Incapital.

The leverage ratio, or SLR, was adopted after the 2007-2009 financial crisis.

While the Fed did not indicate when its SLR review was likely to conclude, hopes were raised that it will address concerns as banks face a flood of reserves caused by the Fed’s unprecedented bond purchases and the Treasury’s decision to slash its cash balance.

“My question is, will the Fed wait until there is a problem before actually reacting? And I think that’s the market’s key concern as well,” said Goldberg.