ABOUT THE AUTHOR
A member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
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.
Figure 1. The money supply is contracting under QT
Sources: Federal Reserve. M2 is a measure of the money supply that includes bank accounts (checking, savings, and time deposits), retail money market accounts, cash, and other liquid assets.
Even if further bank runs are prevented, large unrealized losses can constrain banking activity and earnings. A key feature of this cycle is that households and businesses have extended the maturity profile of debt during the low-interest-rate environment of the past 10 to 15 years, and this is now the banks' problem. The private sector became less sensitive to rising rates, and the Fed had to tighten in a rush. Consequently, households' and nonfinancial businesses' gains became banks' (unrealized) losses.
Banks may buy fewer Treasuries and MBS
Constrained and likely declining bank balance sheets might have implications for the markets in which banks are big participants — especially the Treasury and MBS markets. Unrealized losses might stay on bank balance sheets, waiting to be gradually unwound over time. Given their recent experiences, banks are likely to buy fewer long-maturity Treasuries and mortgages. Commercial banks' Treasury holdings peaked in May 2022 at 7.5% of all outstanding marketable Treasury debt, then declined to 6.4% today. Commercial banks and the Fed together held about one-third of outstanding Treasury securities at the peak and now own about 28%.
Continuing QT, along with these banking sector issues, will further reduce the share of outstanding Treasury debt held by U.S. banks and the Fed. This is happening in parallel with declining foreign ownership of Treasury securities. Just 10 years ago, major foreign owners held more than 50% of outstanding Treasury securities, but their share has declined to 30% today. Foreign central banks do not seem to be selling, except during times of currency interventions, but they have not been buying as much. This is a structural change reflecting decoupling among major economies and the de-dollarization trend. Going forward, more price-sensitive economic agents will be absorbing the increasing Treasury debt.
Amid de-dollarization, price-sensitive agents will absorb rising U.S. debt
Holders of outstanding marketable U.S. Treasury debt (in $B)
Source: Federal Reserve.
Commercial banks' heavy participation in the agency MBS market might be a bigger issue. U.S. commercial banks hold about a quarter of agency mortgages. The Fed owns another quarter, while foreign participation in this market is lower, about 11%. Foreign holders do not seem to have sold mortgages but are not buying them, either. However, the share owned by the Fed and banks will be declining more noticeably. The Fed does not want to hold mortgages on its balance sheet and will continue to wind them down over time. Neither do banks; given mortgages' long maturity and negative convexity, banks' appetite for them is likely to be limited going forward. The only factor supporting the agency MBS market for now is the low level of mortgage originations. With the housing market likely to remain slow, supply might remain low for some time. This dynamic can keep mortgage spreads only on a gradual uptrend. When the housing market starts to recover, likely after the recession and/or when the Fed cuts rates, mortgage spreads may not rally as much as other sector spreads, adjusted for risk.
As banks and the Fed shun agency MBS, price-sensitive buyers gain share
Main holders of agency MBS (in $B)
Source: Federal Reserve.
Less bank participation in the Treasury and mortgage markets is likely a medium-term trend. The recession ahead might divert banks away from extending credit and toward owning more Treasuries. Banks are likely to prefer T-bills over long-duration bonds. That is, banks' new preferred habitat might have a steepening effect on the yield curve, rather than pressuring the whole Treasury rates curve higher. However, when the Fed is paying interest on bank reserves, and the yield curve is inverted and pricing in a lot of rate cuts, it is questionable how much curve steepening banks could cause.
Rising Treasury issuance will reduce liquidity
Due to the debt ceiling issue, the Treasury has not been a net debt issuer for months. The Treasury has relied on its savings at the TGA (Treasury General Account) to meet budget needs. This combination has been providing liquidity to global markets, working against the Fed's QT. Global liquidity has been so high that the Fed has had a hard time controlling even the front end of the yield curve. This issue is now being resolved. The U.S. Treasury will quickly be increasing issuance, especially of T-bills, to replenish the TGA and to fund the budget deficit. As liquidity is withdrawn at a time when recession signs are less visible, the new Treasury supply is likely to be issued at higher rates. Independent of QT and further rate hikes, this will tighten financial conditions.
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