Markets Start to Worry About Year-End After Fed Ditches Crisis Measure

The Federal Reserves decision to allow a regulatory exemption for banks to lapse at the end of March has led to a jump in year-end funding premiums.

December Eurodollar contracts -- which are priced off interbank rates -- have come under persistent selling pressure since the central bank said Friday that relief for banks under the supplementary leverage ratio would expire this month as planned. Traders are preparing for greater frictions in dollar borrowing markets now that lenders are expected to be more conservative in managing their balance sheets.

The frictions are mainly manifesting themselves over year-end, a period when regulatory scoring often leads banks to scale back lending. An increasing premium can be seen in December pricing of a key gauge of banking sector risk known as FRA/OIS -- the spread between Eurodollar futures and the fed funds rate -- which has widened two basis points since the Fed‘s announcement. The gap is now seven basis points greater than the FRA/OIS spread for the September contract, which doesn’t cover year-end.

The Fed introduced the SLR relief for banks last year as it sought to support the economy amid the coronavirus pandemic. Under the exemption, it allowed banks to hold extra Treasuries and deposits without setting aside capital for potential losses.

The direct implication of letting the relief expire is tighter bank-level controls over leverage capital, which will create more frictions in over-the-counter derivative markets, Henry St John, a fixed-income strategist at JPMorgan Chase & Co. (NYSE:JPM), wrote in client note.

As allocations of capital get stricter, there will be more bouts of volatility in leverage-intensive markets such as foreign-exchange swaps, he said.

The Feds announcement has also led to a widening in yen-dollar three-month cross-currency basis -- a measure of the cost to access U.S. currency. While the spot rate is around negative eight basis points, the December starting contract -- which covers year-end -- has widened three basis points since Thursday and is now around minus 41 basis points, according to data from Martin Brokers in London. A widening basis indicates a higher premium to hold dollars.

While the Fed allowed the current SLR exemption to lapse, the central bank also said it is seeking comment on further adjustments. This has given markets some optimism that a more permanent solution for the policy will be forthcoming.

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