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Money supply (M2) skydives
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Banks are reporting falling Loan-to-Deposit ratio
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Slowdown in lending will lead to layoffs/bankruptcies
The only times when the money supply was that negative was on four
disastrous occasions, which led to massive trouble for banks:
– Great Depression 1929
– Depression of 1921,
– Panic of 1893,
– 1870s Banking Crisis
The Fed is contracting the money from the system through the Quantitative
tightening (QT) mechanism. The credit crunch hit banks and soon other parts
of the economy as many financial institutions prepare for contracting Loan
to deposit ratio (LDR). Here is evidence from the latest quarterly bank
reports.
First Republic Bank Loans +22.6% YoY,
Deposits –35.5% YoY
JP Morgan Loans +6% YoY, Deposits
–8% YoY
Wells Fargo Loans +6% YoY, Deposits –7%
YoY
This picture goes for the rest of the industry, loans up, deposits
down, leading to sustainability issues.
The inevitable price inflation from printing a couple of trillion dollars
during the Covid-19 Pandemic has forced the Fed to allow interest rates to
rise significantly. Now, banks find they don’t have enough interest income
from those older low-interest securities—to pay the bank’s bills in the
current era of higher interest rates. The first problem signs of this yield
mismatch have appeared with the failures of Silicon Valley Bank and
Signature Bank.
Banks are, therefore, reluctant to raise interest rates on deposits.
This has led to a historic decline in bank deposits as investors seek
yield in other parts of the market, such as money market funds.
Hence banks will have to cut back on loans to account for lower deposits,
leading to fewer mortgages, loans, and ultimately money in the economy,
resulting in tightened lending conditions.
This has been happening in the last quarter and will likely continue. Banks
are tightening credit in response to Fed rate hikes, economic uncertainty,
and money supply contraction, nearing the contractionary levels experienced
during the Pandemic, GFC, Dotcom Bust, and Gulf War Recession.
Not only that but apart from the tighter standards, there is also a weaker
demand for commercial and industrial (C&I) loans to large and
middle-market firms as well as small firms over the first quarter, as
(re)financing at those higher rates is quite expensive.
This suggests a significant slowdown in lending that might lead to a wave
of layoffs/bankruptcies that could culminate in a recession in the second
half of 2023.
On the upside, inflation should continue to roll over. However, given the
velocity at which M2 has fallen, the risk is that the economy could enter a
deflationary period.
This will put much pressure on the Fed to reverse course and start QE (cut
rates and boost money supply), something that the markets are not only
attaching a high probability but are almost certainly expecting to happen
before the end of the year.
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