Deregulation and the Treasury Market: A New Era of Liquidity and Investment Opportunities

The U.S. Treasury market, the world's most liquid bond market, faces a pivotal shift as banking deregulation proposals advance. Recent reforms targeting the Supplementary Leverage Ratio (SLR) and other regulatory constraints could reshape liquidity dynamics, reduce borrowing costs, and create opportunities for investors. This article examines how reduced oversight could bolster Treasury market resilience while cautioning against potential risks, such as heightened volatility.

Regulatory Overhaul: The SLR and Beyond

The SLR, which requires banks to hold capital against risk assets, has long constrained their ability to intermediate in the Treasury market. The 2020 pandemic-era temporary exemption of Treasuries from SLR calculations demonstrated its power: it boosted liquidity and stabilized markets during extreme volatility. Current proposals aim to make this exemption permanent, potentially freeing up up to $1 trillion in bank Treasury holdings.

Other reforms include:
- Tailoring regulations for community banks to reduce compliance burdens.
- Revising stress tests to prioritize transparency and reduce capital volatility.
- Rejecting Basel III's “Endgame” in favor of U.S.-centric rules.

Historical parallels suggest this could work. The 2020 SLR waiver improved dealer balance sheets, enabling them to absorb Treasury sell-offs without cascading liquidity crises.

Impact on Liquidity and Yields

The reforms directly address a key vulnerability: Treasury market illiquidity. By easing capital constraints, banks will have greater incentive to act as market makers, narrowing bid-ask spreads and reducing trading costs. This should lower long-term yields, as increased demand for Treasuries compresses rates.

The swap spread—a gauge of Treasury liquidity—is already responding. Swap spreads (the difference between Treasury yields and interest rate swaps) narrowed from -46 to -37 basis points in 2024 as deregulation expectations grew. This trend could continue, signaling healthier market conditions.

Investor Strategies: Positioning for Liquidity and Yields

The reforms create a compelling case for intermediate-term Treasuries (5–10 years) and Treasury Inflation-Protected Securities (TIPS).

1. Intermediate Treasuries:
2. Why? These maturities benefit most from yield compression and reduced volatility.
3. Data: The 10-year Treasury yield has averaged 4.5% since 2023, but SLR reforms could push it lower toward 3.5–4% by 2026.

4. Risk Management: Pair with short-dated Treasuries (e.g., 2–3 years) to hedge against sudden rate hikes.

5. TIPS:

6. Why? Inflation remains elevated, and TIPS offer principal adjustments tied to the CPI. Their real yield (yield minus inflation) is attractive amid Fed rate cuts.
7. Data: The 10-year TIPS breakeven rate (a proxy for inflation expectations) has hovered around 2.2%, suggesting TIPS could outperform nominal Treasuries if inflation stays sticky.

Risks and Considerations

While deregulation promises benefits, risks persist:

• Volatility Risks: Reduced bank capital buffers could amplify shocks. For example, leveraged basis trades—already a $1 trillion market—might overheat, leading to abrupt sell-offs.
• Regulatory Overreach: A pendulum swing toward deregulation could weaken post-2008 safeguards. The 2023 Silicon Valley Bank collapse, fueled by poor risk management, serves as a cautionary tale.
• Global Contagion: Treasury market dislocations could spill into other markets, as seen during the 2020 repo crisis.

Conclusion: A Balanced Play for Liquidity and Safety

The U.S. banking deregulation wave presents a strategic entry point for Treasury investors. By prioritizing intermediate Treasuries and TIPS, investors can capitalize on improved liquidity and yield compression while hedging against inflation.

Investment Recommendation:
- Allocate 40% to intermediate Treasuries (e.g., iShares 7-10 Year Treasury Bond ETF – IEF).
- Allocate 30% to TIPS (e.g., iShares TIPS Bond ETF – TIP).
- Hold 30% in short-term Treasuries or cash to manage volatility.

Monitor policy developments closely. If SLR reforms stall, consider rotating into investment-grade corporate bonds (e.g., iShares iBoxx $ Investment Grade Corp Bond ETF – LQD) for yield pickup.

The Treasury market's future hinges on balancing deregulation with prudence—a dance investors must navigate with care.

Jeanna Smialek is a pseudonym for an analyst specializing in fixed income markets. The views expressed are the author's own.