Contracting M2 Money Supply and Fed’s QT Add Bank Stress on MBS Markets

Stress in the banking sector — whether or not more banks fail — remains an area of concern for us because of potential implications for the Treasury and agency MBS markets.

  • The contracting money supply (M2) will reduce the aggregate commercial bank balance sheet and bank earnings.
  • Banking sector issues combined with the Fed's quantitative tightening are likely to cause U.S. banks to hold less Treasury debt.
  • Higher Treasury issuance following the debt ceiling resolution will reduce global liquidity and could, by itself, tighten financial conditions.

Contracting M2 money supply shrinks bank balance sheets

Fearmongers have been pounding the table about the dangerous contraction in the U.S. money supply, but considering the relatively narrow definition of M2, we believe this does not really mean the end of the world. Major contractions in capital markets always come with contractions in the broadest measure of money. The money supply had been artificially inflated in the early days of the Covid pandemic — the inflated supply was not created by the banking sector. M2 has been coming down as excesses are cleared out. Since the first quarter of 2022, thanks to the Federal Reserve's tightening, aggregate household wealth has been declining, and so has M2.

The Fed's rate hikes along with QT reduced household wealth. Gradual retail deposit outflows are a consequence of this. Student loan repayments that are soon starting will be enhancing the trend. In addition, businesses have been reducing demand for loans, partly in response to higher rates and tighter credit standards. Low or negative bank loan growth will likely add to the destruction of money that is already in train. As a consequence, the aggregate commercial bank balance sheet will be declining. This is assuming, of course, the Fed does not do QE all of a sudden (not full quantitative easing, necessarily, but a narrow program meant to address a market malfunction). A decline in the U.S. aggregate commercial bank balance sheet means a decline in aggregate bank earnings.

The money supply is contracting under QT