AS BONDS TUMBLE, MIGHT THE FED SOON TAP ITS TOOL BOX?

Treasury market volatility is intensifying, with the Benchmark U.S. 10-year Treasury yield US10Y jumping to a seven-week high on Wednesday. The sharp increase in yields during the Asian trading day increased fears that China may be offloading a large portion of its U.S. bond holdings.

As Thomas Simons, chief U.S. economist at Jefferies, sees it, liquidity conditions are starting to resemble the Spring 2020 "Dash for Cash."

Demand for longer-dated debt is set to face a test with a $39 billion sale of 10-year notes later on Wednesday and a $22 billion auction of 30-year bonds on Thursday. If market conditions continue to deteriorate, Simons thinks we could soon see the Fed once again dip into its toolbox.

On such tool he thinks the Fed could deploy would be the exemption of Treasuries and Reserves from Supplementary Leverage Ratio (SLR) requirements. Simons say this would help to increase banks' and dealers' capacity to increase their balance sheets and warehouse securities sold by weaker hands.

"In our view, returning to this policy would be a big help in stabilizing the Treasury market before conditions deteriorate to the point where more intervention is needed," writes Simons in a note.

As for cutting interest rates, Jefferies' base case is still for three rate cuts this year - in June, July and September. And Simons says that although tariffs may cause price increases, he does not think it's right to assume that the Fed would view these increases as a handcuff.

That being said, Jefferies doesn't think a cut right now, ahead of anticipated weaker data/economic conditions, would be the best move.

Another measure Simons kicks around would be for the Fed to expand the size of its balance sheet and increase the amount of reserves in the system, while also continuing its fight against inflation. Specifically, when Silicon Valley Bank failed, he says the Fed deployed the Bank Term Lending Program, which he says was essentially a "turbo-charged discount window."

As for large-scale purchases of Treasuries (QE), Simons believes that would be a last resort, saying "The tool is there, but it is far too blunt to address the current situation."

He adds that "Mass purchases of Treasuries might raise questions about the monetization of debt in the US, and further weaken the market's appeal among foreign investors. We do not expect that the Fed will start buying bonds again any time soon."

(Terence Gabriel)

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