SLR Relief

At this point, I think providing Supplemental Leverage Ratio (SLR) relief for banks to hold more Treasuries is a fait complete. High and rising issuance with an expanding deficit, and declining foreign demand, make it inevitable.

US poised to dial back bank rules imposed in wake of 2008 crisis (FT)

US authorities are preparing to announce one of the biggest cuts in banks’ capital requirements for more than a decade, marking the latest sign of the deregulation agenda of the Trump administration.

A move to dial back the SLR would be a boon to the Treasury market, analysts say, potentially helping Trump achieve his goal of reducing borrowing costs by allowing banks to buy more government debt.

A Bloomberg opinion piece pushes back. America Needs to Be Strong. Why Weaken Its Banks? (Bloomberg)

Treasury Secretary Scott Bessent has a plan to prop up a government-bond market destabilized by Washington’s chaotic economic policies: Let banks load up on federal debt.

This would be a questionable idea in any environment. At a time when America’s reliability is in doubt, it’s irresponsible.

So let’s answer the question Bloomberg poses.

SLR Relief + Fed’s SRF = Stealth Monetization

Traditionally, debt monetization refers to a central bank directly or indirectly financing government deficits by purchasing sovereign debt, often in the primary or secondary market. This increases the monetary base and is usually associated with concerns about inflation or fiscal dominance.

The Supplemental Leverage Ratio (SLR) is a post-crisis capital rule requiring large banks to hold a minimum amount of capital against all assets, including risk-free assets like Treasuries and reserves. SLR relief refers to temporarily or permanently excluding Treasuries or reserves from the denominator of the SLR, making it easier for banks to expand their balance sheets (i.e., buy more Treasuries) without breaching capital constraints.

Alone, strictly speaking, this is not debt monetization as the Fed is not purchasing the debt and there is no increase in the monetary base.

But then there are two questions:

1. How will the banks fund these purchases?

2. What debt will the banks purchase?

Funding Through Standing Repo Facility

Most likely, banks will fund their purchases of Treasuries through short-term repo financing. But the banks can also fund their Treasury purchases through the Fed’s Standing Repo Facility (SRF).

The SRF is a Fed backstop that effectively allows banks to convert Treasuries into reserves on demand. That means banks face little or no liquidity risk from holding Treasuries — they can always get cash from the Fed against them.

Functionally, this begins to resemble the central bank intermediating between the Treasury and the private sector, even if no outright purchase occurs.

Duration Risk: Bills vs Bonds

Many commentators naively tend to chastise the Treasury for not issuing longer-term debt. But the Global Financial Crisis has shown that the aggregate amount of risk was too high for the markets to handle; that’s why the Fed took duration risk from the market onto its own balance sheet.1

Now, banks could purchase short-term bills and fund them through repo adding only minimal amounts of duration risk. This is almost riskless maturity transformation, however it looks like regulatory arbitrage enabled by SLR relief, not macroeconomic risk-taking.

Alternatively, banks could purchase longer-duration notes and bonds. But this would add material duration risk, given that they are unlikely to be able to match fund the assets (and banks are in the business of maturity transformation after all). Banks could wind down other activities that generate longer duration assets (such as term lending) though I doubt policymakers are looking for that outcome.

Interest rate risk, of course, does not have a risk-based capital charge, but from a ‘safety-and-soundness’ perspective banks would need significant regulatory forbearance to run this risk (Perhaps this is why Mr. Besset wants greater control of the regulatory agencies).

In this case, the Fed and the US government are bearing the real tail interest-rate risk though lender-of-last-resort and the systemic risk exemption. The banking system is more fragile.

So, SLR relief is not just a technical change — it becomes a policy choice to allocate sovereign debt absorption and interest rate risk to the banking system, potentially backed by the Fed.

Short-duration debt + repo funding looks like a regulatory liquidity loop, not classic monetization.

Long-duration debt + repo funding via the Fed begins to resemble a quasi-monetization regime with systemic maturity mismatch risk — especially if it becomes structural.

Threats To US Dollar Reserve Status - Swap Lines

Big tip of the hat to Steve Kelly. for staying focused on this issue.

One aspect of maintaining reserve currency status is providing liquidity in the currency to foreign-domiciled firms. The Federal Reserve's dollar swap lines are bilateral agreements with foreign central banks designed to provide liquidity in U.S. dollars during times of financial stress. These arrangements allow the Fed to exchange dollars for foreign currencies with partner central banks, which then lend the dollars to institutions in their jurisdictions. The Fed has standing swap lines with five major central banks, and additional ‘temporary’ lines with about a dozen more.

Similarly, The People's Bank of China (PBoC) has established an extensive network of bilateral currency swap agreements with foreign central banks, aiming to promote the international use of the renminbi (RMB). They currently have agreements with 4- central banks.

Europeans Worry About Reliability of US Swap Lines

ECB presses banks on dollar funding over Trump concerns (Reuters)

European Central Bank supervisors are asking some of the region's lenders to assess their need for U.S. dollars in times of stress, as they game out scenarios in which they cannot rely on tapping the Federal Reserve under the Trump administration, three people with knowledge of the discussions said.

Nearly one-fifth, opens new tab of euro zone banks' funding needs are denominated in U.S. dollars, with the lenders borrowing in markets for short-term funding that can shut down abruptly in times of financial stress.

IMF Global Financial Stability Report

Brazil Engages In Swap Line With PBoC

In line with the damage done to the US dollar’s standing, foreign central banks are increasingly hedging their bets. In this case, China is already a larger trading partner for Brazil than is the US.

Banco Central do Brasil e Banco Popular da China assinarão acordo de swap de moedas

The presidents of the Central Bank of Brazil (BCB) and the People's Bank of China (PBOC), Gabriel Galípolo and Pan Gongsheng, will sign a currency swap agreement between the central banks at an event in Beijing on Tuesday. The main objective of this agreement is to provide liquidity to facilitate the functioning of financial markets if necessary. As stated in CMN Resolution No. 5,211, the maximum outstanding value of the operations resulting from this agreement is R$157 billion and the validity period is 5 years.

The BCB has a similar agreement with the FED, called FIMA (Foreign and International Monetary Authorities Repo Facility), which allows the BCB to have access to US dollars through a repo operation, with US treasury bonds as counterpart. This arrangement with the FED became permanent in 2021.

The PBOC already has 40 currency swap agreements with central banks similar to the one that will be signed with the BCB. Among the signatory countries of these agreements with China are Canada, Chile, South Africa, Japan and the United Kingdom, in addition to the Eurozone, through the European Central Bank.

These currency swap agreements have become common among central banks, especially since the 2007 crisis. The BCB is already in talks with other central banks to carry out agreements similar to the one that will be signed with the PBOC tomorrow.

Tariffs

Current Estimate of Trump-2 Tariffs

Details on how they arrived at the figures are on his tweet steam

Trade Tensions and Tariff Shocks: What the New Research Reveals

The Trump administration's renewed use of tariffs has reignited academic interest in the real economic consequences of trade frictions. Recent papers offers fresh empirical and theoretical evidence on the effects of tariffs, extending beyond traditional models of static inefficiencies and terms-of-trade arguments.

Long-Run Effects of Trade Wars

In a sharp departure from static models, Baqaee and Malmberg argue that the real cost of trade wars lies in how they affect capital formation.

When the capital stock is allowed to adjust, long-run consumption and wage responses are both larger and more negative.

Their model shows that U.S. consumption could fall by 2.6% in response to recent tariffs, compared to 0.6% under the common assumption of fixed capital. The reason:

Trade wars increase the relative price between investment goods and labor by taxing imported investment goods and their inputs... depressing capital demand, shrinking the long-run capital stock, and pushing down consumption and real wages.

Who Benefits From Trade Wars?

Cen, Cohen, Wu, and Zhang analysis shows that U.S. firms with strong political ties—especially those that supply the federal government—were able to increase their imports from China during the height of the trade war. These firms were twice as likely to receive tariff exemptions and were significantly more profitable than their untied counterparts.

Government-linked firms actually significantly increase their importing activity following the onset of formal sanctions... roughly 30% (t = 4.23), following the shock.

These firms were also twice as likely to receive tariff exemptions as peers. One example:

Honeywell applied for 25 tariff exemptions... and got 6 of them approved. This implies an approval rate of 24%, while the average was only 12.9%.

The lesson? Policy exposure is not symmetric; it can be hedged—if you have the right friends. Yup - this sounds like Trump’s MO.

The Macroeconomics of Tariff Shocks

Auclert, Rognlie, and Straub derive a simple recession condition in a New Keynesian trade model:

“Temporary tariffs cause a recession whenever the import elasticity is below an openness-weighted average of the export elasticity and the intertemporal substitution elasticity.”

Big economist words. What they are saying is if people and businesses can’t easily replace imports with domestic goods, they can easily cut back spending; then the tariffs make the economy shrink — and we get a recession. They argue that in today’s world, this condition is likely to hold:

“It is easier to lose competitiveness on the global market than to substitute between home and foreign goods.”

Even temporary tariffs can lead to stagflation.

Tariff shocks are inherently stagflationary: unlike cost-push shocks in the standard New Keynesian model, they are contractionary even in the absence of a monetary reaction. … Equal retaliatory tariffs from abroad... make recession all but certain.”

How Tariffs Affect Trade Deficits (MIT)

Costinot and Werning’s work adds a formal foundation to the asymmetric transmission of trade policy through expectations and asset prices. I think this is directly related to Miran’s arguments, but the deep economic theory here is beyond my full comprehension.

… Our main result provides a sufficient statistic to evaluate the impact of tariffs around free trade: tariffs reduce trade deficits if the Engel curves for aggregate imports and exports are convex. Convexity is more likely when goods, at the micro-level, shift between being imported, non-traded, or exported. If this extensive margin is inactive and Engel curves are linear, then a permanent tariff is neutral

Costinot & Werning show that tariffs only reduce trade deficits under specific conditions:

1. If Engel curves are convex (i.e., imports behave like luxury goods),

2. If there's an active extensive margin (goods move in and out of trade depending on conditions),

3. And if the deficit is large enough to create asymmetry between time periods (which is common in real-world deficits).

It seems like conditions 2 & 3 are met, but I don’t know much (anything) about Engel’s curves, so wiser minds than me will need to figure out if “Engel curves are convex.”

Here is a Twitter stream by Werning that discusses the paper.

Understanding the Effects of Tariffs (AEI)

The American Enterprise Institute reminds us that tariffs are taxes—and regressive ones at that.

Tariffs reduce the after-tax return on work and investment, distort the allocation of resources in the economy, and ultimately reduce economic output in the long run.

While the Trump administration has promoted tariffs as a source of revenue and leverage, AEI finds the costs substantial:

Tariffs cannot permanently change the trade balance. Tariffs that reduce imports result in an equivalent reduction in exports in present discounted value, reducing overall trade but not the trade deficit.

Moreover, tariffs have fiscal consequences:

Tariff revenue rose from 1% of federal revenues in 2017 to 2% in 2019… but only at the cost of lost output and higher consumer prices.

The Cynic In Me Says “It’s All About Christmas”

Anna Wong is the Chief Economist at Bloomberg.

Any economists out there feel free to comment:

Moodys Downgrades US to Aa1

Most of us just LOL’d. A former Chief Credit Officer friend proposed downgrading the US internally probably a decade and a half ago (or longer). Certainly before S&P and Fitch originally downgraded the US.

Moody's Ratings downgrades United States ratings to Aa1 from Aaa; changes outlook to stable

Successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat. In turn, persistent, large fiscal deficits will drive the government's debt and interest burden higher. The US' fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.

Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable (2023)

United States of America Long-Term Rating Lowered To 'AA+' On Political Risks And Rising Debt Burden; Outlook Negative 2