It’s been popular to link swings in stocks and other asset prices to changes in the balance sheets of the Federal Reserve and other major central banks, but the data doesn’t back up that idea, a market economist argued in a Thursday note.
Of late, the argument has centered on this year’s first-half stock-market rally that has continued into July, noted Dario Perkins, managing director for global macro at TS Lombard.
The thesis holds that despite the Federal Reserve’s monetary tightening efforts, the injection of money into the financial system in March in response to regional banking woes and the rundown of the Treasury Department’s general account amid the debt-ceiling fight in Congress provided fuel for stock-market gains.
Perkins said investors have been “obsessed” by charts, similar to the one below, showing a supposed relationship between the Nasdaq Composite
COMP,
and Fed provided liquidity, as measured by the central bank’s balance sheet minus its reverse repo program and the Treasury General Account.
But those types of charts are misleading, Perkins said, because you can only assess correlations by looking at changes in variables, not their levels — especially when looking at two series that are both rising.
Now that central bank liquidity is set to shrink again, some pundits and analysts predict gloom. So-called quantitative tightening, in which central banks shrink balance sheets swollen by bond buying during so-called quantitative easing periods will no longer be offset by the rundown of the Treasury General Account.
The European Central Bank is running down its balance sheet at a record pace and the Bank of Japan might eventually tweak its program of yield-curve control, ostensibly reducing the bid for global financial assets, Perkins said.
But a closer look at correlations between QE and asset prices doesn’t back that up, he argued.
“To start, there is no stable relationship between asset prices and central banks’ balance sheets (even in the QE era),” Perkins said. The chart below takes another look at the relationship between the Nasdaq and the Fed’s QE program:
On a global scale, the chart below tracks the MSCI World Index
990100,
and combined Fed, ECB and BoJ QE. It shows central bank liquidity explains only a fraction of asset-price swings, Perkins noted.
“The weak correlation between QE and asset prices is not surprising. Central banks are responsible for a tiny part of true liquidity in financial markets. True liquidity is about access to funding and ‘balance sheet,’” he wrote. “Liquidity is B.S.!”
The Nasdaq, fueled by a frenzy over artificial intelligence software, has rallied around 35% so far in 2023, while the S&P 500
SPX,
has gained around 19%, and the Dow Jones Industrial Average
DJIA,
has advanced 6.6%.
What’s being ignored by the focus on central banks, Perkins said, is the amount of leverage and collateralized borrowing that takes place in the modern financial system, especially the shadow banking sector. That means liquidity is now flexible and “elastic” to the needs of the economy. “There is no fixed amount of ‘loanable funds,’” he said.
To the extent liquidity is meaningful, it must be about more than whether central banks are expanding or shrinking their balance sheets, Perkins said. “True liquidity is about access to funding.”
So what does that mean for the market? Further stock market gains will require that access, which could come easier if artificial-intelligence technology lives up to its hype. Meanwhile, tighter monetary policy doesn’t rule out a further rise for risk assets, he said, pointing to the run-up to the bursting of the dot-com bubble in 2001 as a “cautionary tale.”
“The Dotcom meltup in U.S. tech stocks started with a global growth scare in 1998 and a soft/no landing in the US. Investors became even more convinced they were seeing a new paradigm of the New Economy. No more boom and bust! Tech productivity boom!” Perkins said. “Could we see something similar?”
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