By Jamie McGeever
ORLANDO, Florida (Reuters) – One of the many curiosities of 2024 has been how global stocks have surged so strongly even as central banks have drained liquidity from the system. The question for markets is, if draining liquidity wasn’t much of a headwind this year, will its likely reversal next year turn into a tailwind?
Global growth is forecast to moderate, partly due to the heightened uncertainty surrounding U.S. trade policy, and key economies like China, Europe and Canada are expected to loosen monetary policy significantly.
Meanwhile, the Federal Reserve is trimming interest rates and could wind down its quantitative tightening (QT) program which has shrunk its balance sheet by $2 trillion since mid-2022.
In short, the liquidity drain is likely to end.
But if tracking the level of liquidity coursing through financial markets and the global banking system is hard, accurately assessing its impact on asset prices is a near-impossible endeavor.
Liquidity has often been measured, albeit crudely, by the size of central bank balance sheets, with the assumption being that bigger balance sheets – and especially higher levels of bank reserves – mean stronger equity markets.
For example, analysts at Citi run a model which suggests every $100 billion change in bank reserves held at the Fed equates to a roughly 1% move in the S&P 500. That would mean Wall Street should have taken a 2% hit this year, all else equal, as reserves fell by around $200 billion.
On a global level, the 12-month change in bank reserves is around $600 billion, implying a much bigger fall in world stocks. Of course, the S&P 500 is up nearly 30% this year and the MSCI World index is up 20%.
Or consider that the combined size of the ‘G4’ central bank balance sheets fell by $2.2 trillion in both 2022 and 2023, yet world stocks fell 20% in one year, then rose 20% the next.
All this suggests liquidity is only one of many factors impacting markets. Economic growth, geopolitics, technology, earnings, regulation, investor psychology and a host of other factors can sway markets from day to day.
Does this mean investors can mostly disregard changes in liquidity? Not necessarily.
COLOSSAL
When trying to assess the status of market liquidity implied by central bank balance sheets, it’s useful to zoom in on bank reserves. If they get too low, as appeared to happen in the U.S. in 2019, money market rates can spike, credit crunch fears can flare up and investors may begin dumping risk assets.
New York Fed models and recent commentary from Fed officials have both indicated that current U.S. bank reserves of around $3.2 trillion are “abundant”. However, they would like them to be merely “ample”, which is what the Fed’s ongoing balance sheet reduction is seeking to achieve.
Policymakers will be pleased that – at least thus far – this reduction has not seriously impacted financial markets. It has been “like watching paint dry,” as U.S. Treasury Secretary Janet Yellen once quipped.
But early 2025 could be choppy for markets, prompting the Fed to call a halt to QT. President-elect Donald Trump returns to the White House, the U.S. debt ceiling issue could rear its head again, and cash at the Fed’s overnight repurchase facility (RRP) could hit zero, signaling the disappearance of what some Fed officials have deemed a rough proxy for “excess” liquidity.
Analysts at Goldman Sachs reckon the Fed will end QT in the second quarter, and others say it could come earlier.
And why not? The balance sheets of the Fed, European Central Bank and Bank of England are all the smallest they’ve been as a share of their respective GDPs since early 2020, before the pandemic.
David Zervos, chief market strategist at Jefferies, at a conference in Miami in February predicted that QT will stop with the Fed’s balance sheet at $7 trillion, right where it is today.
“That’s a colossal balance sheet … a huge stimulus. It lifts earnings, lifts nominal GDP, lifts profits and lifts valuations,” Zervos said.
Even if there is no mechanical link between central bank liquidity and markets, a “colossal” Fed balance sheet sends a signal that policymakers want to keep liquidity at stimulative levels and have the market’s back.
The perception of liquidity rising – or not falling – could be enough to fuel risk appetite, potentially giving an already hot market an added tailwind next year.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Peter Graff)
