Dario Perkins, the managing director for global macro at TS Lombard, challenges the popular belief that swings in stocks and asset prices are directly correlated to changes in the balance sheets of central banks.
Questioning the Popular Argument
The recent stock-market rally, which has extended into July, has reignited the debate regarding the connection between Federal Reserve monetary policies and stock-market gains. Many believe that despite the Fed’s efforts to tighten monetary policy, the injection of money into the financial system in response to regional banking issues, as well as the reduction of the Treasury Department’s general account amid the debt-ceiling fight, provided the impetus for these market gains.
The Misleading Charts
Investors have been fixated on charts that supposedly demonstrate a relationship between the Nasdaq Composite and liquidity provided by the Federal Reserve. However, Perkins argues that these charts can be misleading because they focus on levels rather than changes in variables. This is particularly important when assessing correlations in two series that are both rising.
Quantitative Tightening and its Implications
As central bank liquidity is set to decrease once again, some experts anticipate a period of gloom. The practice of quantitative tightening, in which central banks reduce their balance sheets after bond-buying during periods of quantitative easing, will no longer be offset by the reduction in the Treasury General Account.
The European Central Bank is reducing its balance sheet at an unprecedented rate, while the Bank of Japan may also modify its yield-curve control program. These actions might potentially decrease the demand for global financial assets.
Challenging Correlations
However, Perkins challenges the notion that there is a strong correlation between quantitative easing (QE) and asset prices. He argues that there is no stable relationship between asset prices and central banks’ balance sheets, even during the QE era. A closer examination of the correlation between the Nasdaq and the Fed’s QE program reveals a different perspective.
The Unpredictable Connection Between Central Banks and Asset Prices
On a global scale, the correlation between central bank liquidity and asset prices is not as straightforward as one might think. According to Perkins, a renowned analyst, central banks play a limited role in the true liquidity of financial markets. The MSCI World Index 990100, -0.60% and combined Fed, ECB, and BoJ QE fail to fully explain asset-price swings.
While it may be tempting to solely focus on central banks, Perkins suggests that we should not overlook the significant influence of leverage and collateralized borrowing in the modern financial system, particularly within the shadow banking sector. The true nature of liquidity has evolved to become flexible and “elastic” to accommodate the needs of the economy. Perkins argues that we should redefine our understanding of liquidity beyond the mere expansion or contraction of central bank balance sheets and instead focus on access to funding.
As we venture further into the market, one crucial factor for sustained stock market gains is access to funding. The rise of artificial intelligence software has generated significant attention and has propelled the Nasdaq to an impressive 35% rally in 2023. Meanwhile, the S&P 500 SPX, +0.34% has experienced a gain of approximately 19%, and the Dow Jones Industrial Average DJIA, +0.26% has advanced by 6.6%.
Despite concerns over tighter monetary policies, Perkins believes that risk assets can still continue to rise. Drawing from the cautionary tale of the dot-com bubble burst in 2001, he emphasizes that a similar situation could unfold. The dot-com meltup was preceded by a global growth scare in 1998 and a soft or nonexistent landing in the US. Investors were convinced that a new paradigm of the New Economy had been established, with promises of a tech productivity boom. Ultimately, this belief was shattered.
So, can we expect a similar scenario to unfold? Only time will tell. As we navigate the intricacies of the market, it is essential to consider the nuances of liquidity beyond central banks’ actions and keep a watchful eye on access to funding. With artificial intelligence technology potentially living up to its hype, further stock market gains become more likely. However, invoking the lessons learned from history, we must remain cautious and avoid falling into a sense of unbridled optimism.
