In an interview last week Treasury Secretary Scott Bessent, who has been vocal about his desire to lower the 10-year rate, mentioned what he sees as the Treasury’s toolkit for doing so. One of those measures was the lowering of the supplementary leverage ratio (SLR) for banks, which he described as something that will “allow banks to buy more Treasuries without a big capital charge . . . I expect we will have created a new buyer for Treasury securities.”

The SLR is a binding capital requirement intended to limit excessive balance sheet expansion among large banking institutions. It was introduced as part of the Basel III post-crisis regulatory reforms and implemented in the US beginning in 2014. Unlike risk-weighted capital ratios, which adjust capital requirements based on asset riskiness, the SLR applies uniformly across asset types — treating US Treasuries, reserves, and loans equally, with the goal being to limit banks’ balance sheets from growing too large and limiting systemic risk in a crisis. For US global systemically important banks (GSIBs), the minimum SLR requirement is 5%, meaning they must hold 5% of common equity capital relative to their total leverage exposure. The largest US banks typically maintain an SLR well above the required level, although SLRs have trended lower toward the 5% minimum in recent years.

Source: Sage, Bloomberg 

In response to the significant balance sheet expansion driven by monetary and fiscal interventions, the Federal Reserve announced in April 2020 a temporary exclusion of US Treasury securities from the SLR denominator for bank holding companies. This action was intended to mitigate binding capital constraints arising from a rapid influx of low-risk assets, particularly as banks absorbed deposits and acted as intermediaries in strained Treasury markets.

The exclusion expired in March 2021. Although regulatory agencies indicated they would review the long-term calibration of the SLR, no structural changes have been implemented.

The mechanics of the SLR have direct implications for Treasury market functioning. When Treasuries and reserves are included in the leverage exposure measure, increases in these positions consume balance sheet capacity. As a result, banks may be disincentivized from engaging in market-making or absorbing large Treasury flows, particularly during periods of supply shocks or liquidity stress, especially as the banking sector’s holdings of Treasuries have grown significantly in recent years.

Source: Federal Reserve 

A reintroduction of SLR relief, either through a renewed exemption of Treasuries and reserves or as a recalibration of the leverage exposure definition, would likely produce several market effects:

• Banks would have greater capacity to hold US government securities, potentially reducing auction tail risk and compressing term premia.

• Market liquidity would improve. Reduced balance sheet frictions would enable more active market-making and better absorption of issuance. Also, banks would be more willing to provide financing in the repo market against Treasury collateral, reducing the likelihood of funding stress in short-term markets.

The main trade-off from the loosening of regulatory burden for Treasuries would be its potential negative effect on the broader objective of systemic resilience. The SLR was designed to provide a capital floor regardless of portfolio composition. Minimizing this requirement could risk reintroducing moral hazard, particularly in a financial system where perceived safe assets dominate balance sheets. A regulatory decision to relax the SLR would create more capacity for Treasury purchases, but they do not necessarily compel banks to buy Treasuries. Additionally, the Federal Reserve would have to loosen this requirement, which may prolong the process as it requires Treasury/Fed coordination.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

There are decades where nothing happens, and then there are weeks where decades happen. Last week, the tariff stress that shocked equity markets spread across fixed income and foreign exchange markets, threatening financial stability and resulting in a delay of reciprocal tariffs from the US as well as a shift in tone from both White House officials and Fed speakers.

Following the tariff announcements on April 2, the chorus calling for recession grew, seeing an initial classic “flight to quality” pattern that is expected in negative economic growth shock episodes. Last week, market stress morphed into something worse, as rates traded sharply higher and the USD uncharacteristically weaker, as a system-wide deleveraging took place, particularly in leveraged positions. Falling equities, rising yields, wider spreads, and higher transaction costs are all indicative signs of a classic liquidity squeeze.

Source: Sage, Bloomberg 

Some corners of the market displayed stress that pointed to deterioration in the functioning of the US Treasury. Swap spreads measure the difference between the interest rate on a swap and the yield on a Treasury bond with the same maturity. When the spread is wider, it means Treasury bonds are more valuable compared to swaps, and when the spread is narrower, swaps are more valuable. Since the supply and demand for Treasury bonds significantly influence these spreads, changes in swap spreads can indicate the market’s expectations for Treasury bond supply and demand.

The market had anticipated a favorable supply and demand for Treasuries following the February 5th Treasury Refunding Announcement, which led to higher spreads and leveraged investors favoring cash Treasuries over swaps. However, last week’s liquidity squeeze caused swap spreads to drop sharply. This was due to expectations of increased Treasury supply from widening deficits during a recession and a lack of buyers for Treasury debt, especially if the US aggressively reduces its trade deficit. We believe that the dysfunction in the Treasury market significantly contributed to the delay of reciprocal tariffs on April 9th. Ultimately, these disruptions should stabilize as liquidity conditions improve, particularly since Fed officials have indicated their readiness to intervene and maintain financial stability.

Source: Sage, Bloomberg 

While the liquidity issues plaguing the markets can be alleviated by Fed intervention or incrementally improving headlines, the structural shift to aggressively collapse the US trade deficit with its trading partners could have wide ranging long-term implications. In particular, the aggressiveness of the tariff rollout threatens weakening the dollar’s global reserve status. After sanctions on Russia following the Ukraine invasion led to the development of a financial network outside of the US dollar system, the current tariff battle represents another phase of economic warfare. This could further encourage a shift away from dollar-based trade.

The US bond market depends heavily on foreign investors. Any significant move away from the dollar would reduce the ability to finance the US’s twin deficits (fiscal and trade). While other markets may not be as deep or liquid as the dollar-denominated bond market, there hasn’t been a compelling reason for foreign investors to look for non-dollar investment options until recently. US policymakers should be cautious not to create such a reason. It’s important to remember that capital will always flow to where there is demand.

Source: Sage, IMF, Bloomberg 

 

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

 

Last week President Trump announced tariffs on nearly all US trading partners, a move that far exceeded the most pessimistic expectations of market participants. The substantial amount and the haphazard manner of the announcement caught markets off guard. While tariffs were anticipated due to presidential campaign rhetoric and Trump’s intense focus on addressing the US trade deficit, the actual announcements were more aggressive than anticipated and markets reacted accordingly. The tariffs, calculated as a percentage of the 2024 trade deficits with the US, resulted in an effective rate of approximately 22.5% across the board, a significant increase from the 2.5% rate in 2024.

Source: US International Trade Commission, Yale Budget Lab

While the historically high tariff rate is intended to be a starting point for negotiations and is expected to decrease, the high initial rate means that the final negotiated levies will likely be higher than anticipated. These tariffs are set to be implemented almost immediately, giving little time for partners to negotiate before they take effect. Given that bilateral negotiations with affected trading partners could take months, the elevated tariffs could remain in place for an extended period. Additionally, the risk of retaliation and escalation from trading partners is significant, as evidenced by China imposing retaliatory tariffs less than 24 hours after the Liberation Day tariffs were announced.

Markets reacted sharply to the unexpected announcement, with the US equity market experiencing its largest two-day decline since 1940. This led to a flight to quality, resulting in a rally in rates and widening spreads.

Treasury yields dropped sharply after the announcement. Tariffs typically lead to higher prices for companies and consumers, but the immediate market reaction was to anticipate a near-term drop in aggregate demand and a slowdown. Inflation expectations decreased, with the TIPS breakeven inflation rate falling by 14 basis points, indicating the market’s expectation of a negative growth shock in the near-term. The FOMC is now expected to cut rates by at least 100 basis points this year. In his remarks on April 4^th,  Jerome Powell indicated it was too early to gauge the appropriate monetary policy stance, while expressing concern about both rising prices and falling growth.

Source: Sage, Bloomberg 

Credit spreads widened from their historically tight levels, with investment grade corporates increasing by 16 basis points to 1.09%, and high-yield bonds rising by 93 basis points to 4.27% over treasuries. Although credit markets are experiencing their worst repricing since 2024, spreads are still not at crisis or recessionary levels and remain on the lower end of historic averages. While there is potential for spreads to widen further, especially with tariffs posing a real threat to economic expansion, we believe fixed income inflows should remain strong. “Yield buyers” are likely to take advantage of the high yields amid high equity volatility and substantial money market assets facing lower forward yields. Any sharp increases in yield should result in solid demand, particularly in IG bonds.

Source: Sage, Bloomberg 

Shrinking economic activity and heightened geopolitical concerns should see fixed income remain well supported. In recent weeks, fears of slowing growth compounded by the negative shocks from potential tariffs and federal job and spending cuts resulted in a shift in the stock/bond correlation structure, which saw high-quality fixed income serve as a diversifier to risky assets after years of moving in tandem with equities. Since the last update in early March, correlations have continued to fall precipitously and are now on par with the negative growth scare in the fall of 2024. We expect this relationship to continue to revert as the risk of a deeper slowdown grows.

Source: Sage, Bloomberg 

The path forward contains more questions than answers at this point. Could the current wave of tariffs push the economy into a recession? Despite the negative market and public reactions, even if tariffs don’t directly cause a recession, market stress could undermine confidence, leading to a deeper slowdown — a phenomenon George Soros famously termed “reflexivity.” It’s too early to make a definitive call, as economic data still indicate solid expansion, with recent job figures exceeding expectations. Additionally, the US private sector is healthy, with household balance sheets much cleaner than in prior debt crises. However, the decline in confidence indicators and the buildup in investment balances in recent years warrant caution.

Tariffs will result in inflation across the global economy, as it is effectively a tax on production. Broadly rising prices results in lower demand and a deeper slowdown in a “stagflationary” dynamic. In that scenario, the Fed will face a dilemma in its monetary policy calibration on whether to raise rates to combat rising prices or lower them to stimulate demand. We believe the Fed will continue to lean toward a dovish approach, prioritizing the demand side of the equation (lower consumption and employment) over the supply side (tariffs), which, despite tariffs being significantly high, they represent a one-time shock to prices.

Lastly, the political factor remains the largest unknown. What is the administration’s “pain tolerance” for the economy and markets and its appetite for negotiation? Also, the other major leg of Trump’s economic agenda, which is the renewal of the 2017 tax cuts along with any spending cuts, will play a big role in the trajectory of the economy and certainly market sentiment. We mentioned in a prior post that we believe tariffs will be a key fixture in trade negotiations, as a tool to extract better trade terms. Unfortunately, the delicate balance of negotiations versus a damaging trade war seems to have tipped in favor of the latter.

 

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.