What drives the stock market higher or lower?
In one word, it’s liquidity.
Below on the left is a bar graph of global liquidity in US$ trillion.
And on the right is the Vanguard Total World Stock Index ETF (VT) over the same time.
Notice the correlation between the two?
Here’s what they look like overlapped together.
Once again it appears central banks are loosening monetary policy again.
Although the Fed and the Bank of Canada are tightening conditions in order to fight inflation, the rest of the world may not be on the same page. And because we live in a global economy, what other central banks across the pond do will ultimately affect our retirement accounts over here at home.
Japan is not worried about inflation
According to Reuters, global strategist Matt King estimates around $1 trillion has been pumped into the global system in the last few months.
The Bank of Japan’s $291 billion purchases of Japanese Government Bonds (JGBs) in January was the central bank’s fourth monthly net purchase in a row. Since October, the BOJ has bought more than $475 billion of JGBs. The purchase was so great it outstripped the combined liquidity drain from the Fed, European Central Bank and Bank of England.
Why is the BOJ aggressively buying bonds? Because it wants to keep its 10 year bond yield low at 0.50%. Any time the yield moves too high the BOJ comes in to buy as much as is required to drop the yield back down to 0.50% again.
This manipulation or “yield curve control” is criticized by many investors in the international community. But with a debt to GDP ratio of 261% I don’t blame the BOJ. The more debt you have, the less you can candle high interest rates.
If I were making monetary policy decisions over there I would probably do the same to provide financial stability.
Ongoing global bailouts
Japan isn’t acting alone. Part of the $1 trillion added to the global system came from China.
Remember the real estate debacle where insolvent Chinese developers halted construction and homeowners refused to continue making mortgage payments? To prevent this from turning into a full blown crisis the PBOC’s liquidity injections in December and January totaled $450 billion.
For context, that’s about 3.5 times more than its total injections in the past 2 years!
And the bank may not be done yet. This BNN article below is from 3 days ago.
King estimates that this $1 trillion injection from all these central banks is enough to push global equities up or down roughly 10%, add or subtract 50 basis points to investment grade credit and 200 basis points to high-yield spreads.
If his estimate is accurate, this means the stock market should actually be 10% lower today if not for these recent actions by central bankers.
The Bank of Japan’s QE is now greater than the Fed’s QT
This graph shows that even though the Federal Reserve (Fed) has been quantitative tightening recently, there has actually been a net surplus of global liquidity because of what other central banks have been doing, especially the Bank of Japan.
Why has the stock market been gaining so much lately? Some attribute it to seasonality, like investors using their new TFSA and RRSP contribution room.
But I think the flows from these central banks give a better explanation for why markets have been so buoyant this year.
So what does this all mean? I think in the short term we may see the stock market move higher before seeing another correction. Also, it’s useful to pay attention to what central banks are doing with their reserves.
As King says, when changes in even the least significant line items on central bank balance sheets are measured in the hundreds of billions of dollars, “they should command investors’ respect.”
By introducing more quantitative easing so readily in the last few months policy makers have made it clear they do not want to crash the global economy. They may talk tough when it comes to fighting inflationary pressures. But when they are forced their hand, it appears they would rather risk higher inflation than financial turmoil.
The Fed will probably capitulate and begin to ease as well. It just hasn’t faced a situation where it’s hawkish tone has been questioned yet. 🙂
Random Useless Fact:
Introverts and telemarketers have something in common.