Dear Hedgeye Nation,
We just hosted 10 of the sharpest investing minds on HedgeyeTV for a 3-day bonanza of world-class interviews. During the final day of our semiannual Hedgeye Investing Summit, Hedgeye CEO Keith McCullough was joined by the Head of Global Research at Alhambra Investments, Jeff Snider.
Below we have transcribed key excerpts from their conversation.
You can access the entire hour-long interview, as well as the 8 other financial market webcasts, here.
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McCullough: Everyone all of a sudden wants to know about the SLR Jeff, so maybe you can dive right into that.
Snider: The Supplementary Leverage Ratio (SLR) “cliff” is supposedly roiling the Treasury market. The SLR is the successor to capital ratios. In the wake of the Global Financial Crisis, authorities realized that capital ratios were essentially worthless, because the banking system had found a number of ways to get around them to stuff their balance sheets full of all sorts of risky assets. At the same time, banks were making risky assets look like risk-less assets so they could create all type of leverage on their balance sheets, which of course unwound in a very messy manner in 2008.
So in the wake of the 2008 crisis, authorities came up with another way to mathematically describe what banks are up to; except now they wouldn’t give them any type of way to game their assets to make them look better than they were.
So that’s what the SLR was – basically a gross measure of a bank’s exposure, based on size, capital offsets, and liquidity measures; banks are given a set of rules they have to follow due to their SLR.
What happened last year as the Fed and the Treasury ramped up their anti-Covid stimulus efforts, they auctioned off a tremendous amount of Treasuries, and at the same time the Federal Reserve underwent a massive expansion of its own balance sheet, which increased the level of bank reserves.
As the banking system absorbed both of those things, the authorities, including the FDIC and OCC, decided that we had to suspend the SLR, otherwise there’d be adverse effects as bank’s balance sheets would be caused to expand too far, therefore causing all these harmful liquidity side effects.
That temporary SLR exemption is set to expire in 2 weeks.
The idea is with the SLR coming back into effect, all these treasuries and reserves that the banking system has added to their balance sheets due to Quantitative Easing will cause some sort of response; the banking system will have to sell some assets to get underneath SLR thresholds, which will cause a lot of disruption in these marketplaces.
McCullough: That’s clear and present danger right now. Yesterday, George Goncalves said he thought they might address it, but just in the Q&A. And low and behold, there you go, and Powell said “2 days.” The market right now is saying it’ll be a non-extension of the SLR, correct?
Snider: I think Powell’s position is that the Fed doesn’t want to extend it.
In some ways they’re enacting something like negative interest rates in a macroprudential way.
The Fed is forcing the banking system to face up to the SLR and saying, “Look, if you want to hold only safe and liquid assets, then pay the surcharge. If the surcharge is too high, then go out and lend!" The Fed has always tried to create portfolio effects via policies that make banks take on risk. What better way to do that then by increasing the balance sheet cost of holding safe assets?
I think the Fed is kind of saying to the banks, “Look, you don’t like lower returns on Treasuries, and that’s going to cost you more on your balance sheet? Then go out and do more risky stuff with it.”
I think they’re trying to do some sort of backdoor, macroprudential way, of forcing risk onto banks’ balance sheets.
McCullough: Now Goncalves was saying they shouldn’t do that, because it’s too fast, too soon. In our career Jeff, how many times has the Fed kicked the can down the road?
So there’s still a chance, particularly with what’s happening in the bond market today, that they might change that. We all know that Powell has a big line to the big house (Wall Street). What’re they calling on today?
Could this change, or is there already inside information on the Street that the Fed won’t extend this thing.?
Snider: Look we’ve had a year here. This is not a surprise; from the Fed’s position, it’s that this isn’t new information, it’s been entirely predictable. If this is a problem, it’s your problem, not mine.
As you alluded to, the Federal Reserve will act tough in the beginning, but as soon as there’s any minor problem, they have a tendency to turn into marshmallows.
Right now we’re in the transition period where The Fed is trying to play bad cop right now; but if Treasury rates get too high, Jay Powell will give in.
From the regulatory perspective, you can understand why the Fed would appear to be serious. Still, at the end of the day, push come to shove, I think people know the Fed will not push this past whatever threshold they have assigned in their model.
It may be already a pre-ordained conclusion, that "if the market does this, then we’ll back off, but up until a certain threshold, we’re going to pretend to be the bad cop and enforce the SLR cliff."