Treasury dealers offload bonds as regulatory deadline approaches

The Treasury market selloff last week came amid signs investors are deleveraging. In a curious twist though, instead of dealer inventories rising as a consequence, they unexpectedly collapsed.

Treasury holdings at primary dealers dropped by a record $64.7 billion to $185.8 billion in the week through March 3, leaving them at the lowest since 2018, according to data from the Federal Reserve released on Thursday.

Typically, when investors offload Treasuries, dealer inventories balloon, as they did in March last year amid the early stages of the pandemic. The breakdown of the most recent data shows the bulk of the decline came from position reduction in under six-year Treasury paper, where holdings fell by $30.8 billion.

One explanation for the disconnect is that dealers are taking steps to trim holdings before the expiry of a key regulatory exemption on March 31. 
 

From April last year, banks have been allowed to exclude Treasuries and reserves when calculating their supplementary leverage ratio as part of crisis measures introduced that month. This allowed them to hold more Treasuries than they otherwise may have done.

Fed officials opted not to provide any guidance on the topic during the recent series of speaker engagements that took place in the run up to the current blackout period before next week’s policy meeting.

Markets appeared to have interpreted this to mean there is a rising risk the exemption will not be extended. Indeed, the view now is that it is something of a coin toss. The shift can be seen in the Treasury market as the spread between bond yields and swap rates has tightened.
 

The latest Fed data also revealed there was a $23.5 billion decline in holdings of Treasury bills. While these have been volatile, continued bill paydowns by the Treasury should gradually shrink this dealer inventory.

There was also an anomaly in six-to-seven year holdings, which rose slightly. This may reflect the disastrous auction during the same week, which saw dealers stuck with 39.8% of the $62 billion sale, or $24.7 billion, the largest ever nominal take-down at a seven-year offering.