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If Liquidity is Your Sword, Keep Swinging

I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.


But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.


If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).

But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.

What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.

So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.


Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.

What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.

I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.

  1. April 29, 2015 at 5:43 am

    Isn’t stock-pumping liquidity significantly enhanced by the ongoing combined $145 billion/month of European and Japanese QE? After all, isn’t money (at least to some extent) internationally fungible? In other words, even though we’re looking at U.S. stocks here does it make sense (in a “stocks are liquidity driven” argument) to look at U.S. M2 in isolation from the rest of the world?

    • April 29, 2015 at 6:33 am

      You are absolutely right, but remember it’s not QE that we care about it’s what the Ms are doing. The Ms are heading higher in both Europe and Japan – up to 5% growth rate in Europe and 3-4% in Japan – with the average of US & Europe M2 (I track this; adding Japan would lower the number but not change the trend) at 5.9% now. That’s near the top of the range of the last few years, but not over the top because US M2 growth has been slowing just a teensy bit too.

      But again, remember the $145bln doesn’t mean anything. Unless it is making it into the money supply, rather than sitting in reserves, it doesn’t mean anything. (This is one reason the Yen isn’t appreciably weaker – the long-term effects of the BOJ QE will trickle in, but so are the effects of Fed QE going to continue to trickle in for a long time. It will take the Fed shrinking its balance sheet or another big BOJ change for the Yen to completely wash out.)

      • April 29, 2015 at 6:41 am

        “…the $145bln doesn’t mean anything. Unless it is making it into the money supply, rather than sitting in reserves…”

        I’m not sure how to define exactly what’s going on with QE vs. asset prices. (Perhaps you can.) It seems completely intuitive to me that if someone (or some institution) was thinking of buying, say, a German bond but gets “crowded out” by the ECB’s buying it with newly-created money, that person will instead put that money into some other financial asset and thereby drive up its price. In other words, the ECB and BOJ are basically telling investors: “We’re cornering the government bond market so you take your money and use it to bid up other asset prices.” Isn’t this essentially what’s happening?

  2. April 29, 2015 at 6:43 am

    “that person will instead put that money…” should instead read “that person will instead put HIS money…”

    • April 29, 2015 at 6:54 am

      Yes, there’s crowding out but that’s not the effect we are talking about when we talk about QE. With QE we care about the QUANTITY of money and don’t much care what they buy; the idea is to get the money into the system. In the US the money hasn’t all gone into the system because it is sitting in bank reserves, and we don’t know how much of that will happen in Europe as well (opinions differ). But the effect you are talking about is the “portfolio balance channel” effect and I pointed out the effects here: https://mikeashton.wordpress.com/2013/01/10/a-relatively-good-deal-doesnt-mean-its-a-good-deal/

      In a nutshell, when the central bank buys all of the good bonds, it forces investors into riskier assets. This was part of the plan all along – the Fed was supposed to substitute for the “animal spirits” by making people eschew expensive safe investments. And that part worked. But the universe of securities isn’t static, and one of the things that happens when the Fed or ECB buys all of the safe bonds is that the market starts producing crappier bonds. Note that Russia…that is, the guys who are invading the Ukraine and saber-rattling around the world…just sold an issue that was so oversubscribed that they’re bringing another one (and larger) right away. Russia. So yes, some of that money goes into equities but a lot of it goes into crappy bonds that wouldn’t exist without the unsated demand for bonds.

      • April 29, 2015 at 7:02 am

        Interesting in that you’re saying that a chunk of the money I’m referencing gets soaked up by additional supply. But then again some of that supply is being used to fund stock buybacks! And meanwhile some of it goes directly into equities. So I guess my core question is: are these asset-price effects (as opposed to “real world/Main Street effects”) from QE properly reflected in any particular “leading indicator” monetary statistic?

      • April 29, 2015 at 7:07 am

        Not sure I understand the question. Money that goes into stocks is still money in someone’s pocket, right? Monetary statistics only count dollars…the way we count what’s happening in those markets is to look at prices – securities prices, or prices for final goods (e.g. CPI). It doesn’t make any sense to have those prices be part of a monetary statistic? Unless I miss your meaning.

  3. April 29, 2015 at 7:16 am

    I guess what I’m saying/wondering is that due to the effect I cited above, in an era of QE tracking M2 would be less useful than ever as a leading indicator for financial asset prices. Do you think this is a correct observation?

    • April 29, 2015 at 3:42 pm

      I don’t think that tracking M2 should ever be a particularly useful indicator for financial asset prices. But the evidence seems to suggest that in an era of QE, M2 is more useful than ever – since it wasn’t at all useful previously.

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