Investors are used to following the changes in interest rates and perceive it as one of the key macro indicators affecting stock market returns and general sentiment. Meanwhile, another less discussed indicator may have an even stronger influence on the stock market returns, especially in the long term. This indicator has a substantial impact on the said interest rates, among other factors.
Summary
- The country’s central bank regulates the money supply in the economy by purchasing or selling debt securities.
- Higher money supply leads to lower interest rates, higher business activity, and higher sales, positively affecting the stock market.
- Historically, the US money supply grew at a steady rate of nearly +0.50% per month, which was accelerated to support the economy amid the Covid-19 pandemic – the Fed added about 5 trillion USD to its balance sheet until April 2022.
- Recently, the Federal Reserve has obtained a money supply reduction policy to remove from its balance sheet value that was amassed during the pandemic and to combat the high inflation while slowing down the economy.
- The stock market may not be able to change its course as long as the Fed continues to decrease the money supply.
Money supply
The money supply in the economy is regulated by the country’s central bank (or Federal Reserve in the United States). To increase the money supply, the central bank would purchase government debt securities. For decreasing the money supply – the opposite would happen – the central bank would sell the government debt securities. Higher money supply in the market leads to lower interest rates (cheaper money), higher spending, and higher inflation – all of which typically boost stock returns.
M2 money supply appreciated almost linearly until February 2020 at a steady rate of nearly 0.50% per month. As the US Federal Reserve accelerated quantitative easing in order to support the economy due to Covid-19 pressure, the money supply growth rate surged to an average of 1.38% per month and continued until March 2022. Starting from April 2022, the US M2 money supply has been decreasing at an average rate of -0.21% per month.
Source: FRED, graph: Author
Reductions in money supply have taken place in history, although smaller and less consistent. Since January 1959, reductions in money supply have occurred 34 times (4.44% of the 776 readings), with an average decrease of -0.16% (-0.13% if excluding the recent outliers) and a median decline of -0.072%. Meanwhile, four out of the ten most significant reductions within this period occurred this year, with an average decrease of -0.41%.
If the Fed aims to return to the money supply level corresponding to the linear growth path characteristic of the period before the Covid-19 pandemic, it would have to reduce the money supply by -0.50% monthly until February 2024, when it would reach 19,764 billion USD.
Fed’s balance sheet
As the Fed engaged in growing the money supply to support the US economy during the Covid-19 pandemic, its balance sheet blew up more than twice to nearly 9 trillion USD. The Fed’s balance sheet doubled during the 2008 Global Financial Crisis and again in its aftermath by the end of 2014.
Now, the same as previously, the Fed wants to reduce its balance sheet to a more stable level. Although, this time, the Fed has chosen a considerably more aggressive strategy. In June 2022, the Fed started its balance sheet normalization process by letting 47.5 billion USD worth of assets mature and roll from its balance sheet. The same happened in July and August. However, in September, the Fed decided to speed up the process and doubled the value of assets to be rolled from its balance sheet to 95 billion USD.
Source: https://www.federalreserve.gov/ Total assets of the Federal Reserve, 01.01.2020.-20.12.2022.
Based on the data available until December 20, 2022, the Fed kept the pace of removing assets off its balance sheet in October and November. Since its peak on April 12, 2022, the Fed balance sheet has been reduced by 401 billion USD. Jerome Powell and other Federal Bank officials have not stated how far they are planning to extend the balance sheet reduction. However, they have indicated that they don’t see any reason for the reduction slowdown. On November 30, Jerome Powell suggested that the Fed doesn’t want to repeat 2019 when the reserves were drawn down too much, but also that “we are not close to reserve scarcity”.
For comparison, let us review the Fed's activities the last time it entered the path of reducing its balance sheet. Last time, the Fed waited almost two years since the first interest rate hike to start reducing its balance sheet – compared to just 3 months this time. Furthermore, previously the Fed chose to gradually increase the assets’ value to be rolled off its balance sheet within 12 months until it reached a 50 billion USD per month peak. This time, the Fed started with almost the same value – 47.5 billion USD – and just after two months, doubled it. Based on the data above, it may be concluded that the Fed is on a more hawkish path than before.
Why is this important?
As discussed previously, the stock market generally enjoys an elevated money supply and generates corresponding returns to investors. Still, how strongly does the money supply impact the stock market? Based on the end-of-month data for M2 money supply and S&P 500 closing price since the beginning of 2013, the correlation between the two measures is impressive: 97%. Meaning that almost every time the money supply grows, so does the S&P 500.
Based on the historical changes of both measures, we see that the S&P 500 index is more volatile – on average, for every 1-point move in money supply, S&P 500 moves 1.47 points. If the money supply were to be reduced by another -7.71% to reach the level corresponding to the linear growth path characteristic of the period before the Covid-19 pandemic, the S&P 500 might follow with a -11.33% drop by the end of 2023.
It is crucial to note that the above-described scenario considers only one measure and its impact on the S&P 500 based on historical data to reflect the money supply’s significance in the stock market’s movements. In reality, other predictable and unpredictable events may significantly impact the stock market’s movements this year. Furthermore, the Fed may change its stance at any point based on the prevailing market conditions.
Stay safe, stay informed, and be well-diversified.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement, or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.41% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Trade this news from Conotoxia Ltd. platforms
Go to your account
