Global six-month real narrow money momentum – a key indicator in the forecasting process followed here – is estimated to have moved sideways for a third month in June, based on monetary data covering 85% of the aggregate.

Real money momentum has recovered from a September 2023 low but remains below both its long-run average and the average in the 10 years preceding the GFC, when short-term interest rates were closer to recent levels – see chart 1.

Chart 1

The expectation here has been that the fall into the September 2023 low would be reflected in a weakening of global industrial momentum into late 2024. DM flash PMI results for July support this forecast, implying a fall in global manufacturing PMI new orders from 50.8 in June to below 50, assuming unchanged readings for China / EM.

Chart 2

The stalling-out of real money momentum at a weak level suggests that economic expansion will remain sub-par in early 2025.

Global six-month industrial output growth, meanwhile, recovered in April / May, crossing back above real money momentum – chart 3. The implied negative shift in “excess” money conditions may partly explain recent market weakness / rotation.

Chart 3

Global six-month real narrow money momentum was held back in May / June by weakness in China and Japan, discussed in recent notes. A US slowdown is a risk going forward.

A note in February argued that expansionary deficit financing operations – “Treasury QE” – have more than offset the monetary drag from Fed QT. Specifically, the Treasury relied on running down its cash balance at the Fed and issuing Treasury bills to fund the deficit in H2 2022 and 2023. The former represents a direct monetary injection while bill issuance is likely to expand broad money because bills are mostly purchased by money funds and banks. (A recent paper from Hudson Bay Capital makes a similar point, referring to variations in the maturity profile of debt sales as “activist Treasury issuance”.)

The February article and an update in May, however, noted that Treasury financing estimates implied that the six-month running total of Treasury QE would slow sharply in Q2 and turn negative in Q3. With Fed QT continuing, albeit at a slower pace, the joint Treasury / Fed impact on broad money was on course to become significantly contractionary.

Treasury QE has fallen as expected and the joint contribution has become negative – charts 4 and 5. Six-month broad money momentum has yet to slow significantly, although three-month growth in June was the weakest since November. Money momentum lagged when the joint impact swung from negative to positive in late 2022 / early 2023.

Chart 4

Chart 5

The approach here places greater weight on narrow than broad money for short-term forecasting. A US broad money slowdown, in theory, could be accompanied by stable or stronger narrow money expansion, for example if rising confidence leads to an increase in broad money velocity, with an associated portfolio shift into demand deposits. Such a scenario, however, is less likely the longer the Fed delays significant rate cuts.

The slowdown in Treasury QE explains a reversal lower in US bank reserves since April – chart 6. The prior rise in reserves, despite ongoing Fed balance sheet contraction, occurred because money funds were running down their deposits in the overnight reverse repo facility in order to buy newly-issued Treasury bills, with the Treasury reinjecting this cash via the deficit.

Chart 6

Japanese bank reserves are also on course to fall as the BoJ embarks on QT – chart 7. Market speculation is that the MPC will announce a reduction in gross JGB purchases to ¥3 trn per month at next week’s meeting, from an average ¥5.7 trn in H1. With redemptions averaging ¥6.5 trn over the last year, this suggests monthly QT of ¥3.5 trn ($23 bn), equivalent to 2.6% of broad money M3 at an annualised rate.

Chart 7

Chinese money trends are puzzling but ominous, suggesting – at a minimum – that the economy will remain weak through H2.

Q2 real GDP growth came in below expectations but there was better news on the nominal side: two-quarter nominal GDP expansion rose for a second quarter as the GDP deflator stabilised – see chart 1.

Chart 1

This improvement tallies with a recovery in six-month rates of change of narrow money and broad credit around end-2023. Money and credit momentum, however, has since slumped, reaching a new record low in June – chart 2.

Chart 2

A post a month ago noted that money – and to a lesser extent credit – numbers have been distorted by a regulatory clampdown on the practice of banks paying supplementary interest. This has resulted in non-financial enterprises (NFEs) moving money out of demand deposits into time deposits and non-monetary instruments such as wealth management products (WMPs), as well as repaying some debt.

The post suggested discounting narrow money weakness and focusing on an expanded broad money aggregate including WMPs. The six-month rate of change of this measure had slowed significantly but was still within – just – the historical range of six-month broad money growth.

That is no longer the case. CICC numbers on WMPs show an outflow in June. Six-month growth of the expanded measure has converged down towards that of conventional broad money – chart 3.

Chart 3

F/x intervention to support the yuan has contributed to monetary weakness but the effect has been minor. Net f/x settlement by banks – which captures spot intervention using the balance sheets of state banks and other institutions – amounted to CNY590 bn ($83 bn) or 0.2% of broad money in the six months to May (a June number is due this week).

Household money growth, it should be emphasised, is stable and respectable: broad money weakness is entirely attributable to a loss of NFE deposits – chart 4. The puzzle is the destination of the “missing” NFE money. Only a small portion is likely to have been used to repay debt: banks’ short-term corporate lending fell in April / May but rebounded to a new high in June.

Chart 4

The focus of monetary weakness on NFEs suggests downside risk to investment and hiring, with negative feedback from the latter to consumer spending.

An analysis of the Fed’s historical behaviour suggests that the conditions for policy easing are in place.

Chart 1 shows the fitted values and current prediction of a logit probability model for classifying months according to whether the Fed is in policy-tightening or policy-easing mode.

Chart 1

The model’s determination for a particular month depends on values of annual core PCE inflation, the unemployment rate and the ISM manufacturing delivery delays index known at the end of the first week of the month (i.e. after the release of the employment report for the prior month).

The model can be thought of as an approximation of the Fed’s “average” reaction function over the last 60+ years. It correctly classifies 87% of months over this period, i.e. the estimated probability of being in policy-tightening mode was above 0.5 in tightening months and below 0.5 in easing months.

There is no memory effect – the model ignores whether the Fed was in tightening / easing mode in the previous month, only considering the above data series (with no dummy variables for “shocks”).

The dependent variable takes the value 1 from the month of the first rate increase in a tightening phase until the month before the first cut in a subsequent easing phase, and 0 otherwise. So a rate plateau before an easing is still classified as part of a tightening phase (and a rate floor before the first hike part of an easing phase).

The tightening / easing phases were identified judgementally and are shown by the shaded / unshaded areas in the chart. The Wu-Xia shadow rate informs the dating of phases during zero-rate periods since the GFC.

The model estimates the probability of the Fed being in tightening mode this month (July 2024) at 0.23, the lowest value since September 2021. Equivalently, the probability of a start of an easing phase is 0.77.

A fall in the tightening probability from 0.62 in March reflects a 0.2 pp rise in the unemployment rate over the last four months (from 3.9% to 4.1%) and a 0.3 pp decline in annual core PCE inflation (from 2.9% to 2.6%).

The Fed is unlikely to announce a rate cut at the conclusion of its next meeting on 31 July, as this would be at odds with recent communications (although the probability may be higher than the 0.05 implied by market pricing on 11 July, according to CME FedWatch).

The model's shift, however, suggests a strong chance of a dovish statement teeing up a September move.

Monetary analysis suggests that the global economy will weaken into early 2025, while inflation will continue to decline. A cyclical forecasting framework, on the other hand, points to the possibility of strong economic growth in H2 2025 and 2026.

Are the two perspectives inconsistent? A reconciliation could involve downside economic and inflation surprises in H2 2024 triggering a dramatic escalation of monetary policy easing. A subsequent pick-up in money growth would lay the foundation for a H2 2025 / 2026 economic boom.

How would equities perform in this scenario? Bulls would argue that any near-term weakness due to negative economic news would be swiftly reversed as policies eased and markets shifted focus to the sunlit uplands of H2 2025 / 2026.

More likely, a significant fall in risk asset prices would be necessary to generate easing of the required speed and scale, and a subsequent recovery might take time to gather pace.

Global six-month real narrow money momentum has recovered from a major low in September 2023 but remains weak by historical standards and fell back in May – see chart 1. The assessment here is that the decline into the 2023 low will be reflected in a weakening of global economic momentum in H2 2024.

Chart 1

A counter-argument is that a typical lead-time between lows in real money and economic momentum historically has been six to 12 months. On this basis, negative fall-out from the September 2023 real money momentum low should be reaching a maximum now, with the subsequent recovery to be reflected in economic acceleration in late 2024.

The latter interpretation is consistent with the consensus view that a sustainable economic upswing is under way and will gather pace as inflation progress allows gradual monetary policy easing.

The pessimistic view here reflects three main considerations. First, economic acceleration now would imply an absence of any negative counterpart to the September 2023 real money momentum low – historically very unusual.

Secondly, the lag between money and the economy has recently been at the top end of the historical range, suggesting that a significant portion of 2023 monetary weakness has yet to feed through.

Highs in real money momentum in August 2016 and July 2020 preceded highs in global manufacturing PMI new orders by 16 and 10 months respectively, while a low in May 2018 occurred a year before a corresponding PMI trough – chart 2.

Chart 2

So a PMI low associated with the September 2023 real money momentum trough could occur as late as January 2025.

Thirdly, stock as well as flow considerations have been important for analysing the impact of money on the economy in recent years, and a current shortfall of real narrow money from its pre-pandemic trend may counteract a positive influence from the (tepid) recovery in momentum since September 2023 – chart 3.

Chart 3

The decline in real money momentum into the September 2023 low began from a minor peak in December 2022, suggesting that the PMI – even allowing for a longer-than-normal lag – should have peaked by early 2024. Global manufacturing PMI new orders rose into March and made a marginal new high in May. However, two indicators displaying a significant contemporaneous correlation with PMI new orders historically – PMI future output and US ISM new orders – peaked in January. The future output series fell sharply in June, consistent with the view that another PMI downturn is starting – chart 4.

Chart 4

Signs of weakness are also apparent under the hood of the services PMI survey. Overall new business has been boosted by financial sector strength, reflecting buoyant markets, but the consumer services component fell to a six-month low in June – chart 5.

Chart 5

Could a weakening of economic momentum in H2 2024 snowball into a deep / prolonged recession? The cycles element of the forecasting process used here suggests not.

Severe / sustained recessions occur when the three investment cycles – stockbuilding, business capex and housing – move into lows simultaneously. The most recent troughs in the three cycles are judged to have occurred in Q1 2023, 2020 and 2009 respectively. Allowing for their usual lengths (3-5, 7-11 and 15-25 years), the next feasible window for simultaneous lows is 2027-28 – chart 6. Cycle influences should be positive until then.

Chart 6

Major busts associated with triple-cycle lows, indeed, are usually preceded by economic booms. Such booms often involve policy shifts that super-charge positive cyclical forces. The 1987 stock market crash, for example, triggered rate cuts by the Fed and other central banks that magnified a late 1980s housing cycle peak.

Could significant policy easing in H2 2024 / H1 2025 similarly catalyse a H2 2025 / 2026 boom? Such a policy shift, on the view here, is plausible because negative economic news into early 2025 is likely to be accompanied a melting of inflation concerns.

The latter suggestion is based on the monetarist rule-of-thumb that inflation follows money trends with a roughly two-year lag. G7 broad money growth of about 4.5% pa is consistent with 2% inflation. Annual growth returned to this level in mid-2022, reflected in a forecast here that inflation rates would move back to target in H2 2024 – chart 7.

Chart 7

The forecast is within reach. Annual US PCE and Eurozone CPI inflation rates were 2.5% in May and June respectively, with a fall to 2% in prospect by end-Q3 on reasonable assumptions for monthly index changes. UK CPI inflation has already dropped to 2.0%.

G7 annual broad money growth continued to decline into 2023, reaching a low of 0.6% in April 2023 and recovering gradually to 2.7% in May 2024. The suggestion from the monetarist rule, therefore, is that inflation rates will move below target in H1 2025 and remain low into 2026.

Central banks have been focusing on stickier services inflation, neglecting historical evidence that services prices lag both food / energy costs and core goods prices. Those relationships, and easing wage pressures, suggest that services resilience is about to crumble, a possibility supported by a sharp drop in the global consumer services PMI output price index in June to below its pre-pandemic average – chart 8.

Chart 8

The approach here uses two flow measures of global “excess” money to assess the monetary backdrop for equity markets: the gap between global six-month real narrow money and industrial output momentum, and the deviation of annual real money growth from a long-term moving average.

The two measures turned negative around end-2021, ahead of 2022 market weakness, but remained sub-zero as global indices rallied to new highs in H1 2024. The latter “miss” may be attributable to a money stock overshoot shown in chart 3 – the flow measures of excess money may have failed to capture the deployment of existing precautionary money holdings.

Still, the MSCI World index in US dollars outperformed dollar deposits by only 3.9% between end-2021 and end-June 2024, with the gain dependent on a small number of US mega-caps: the equal-weighted version of the index underperformed deposits by 8.4% over the same period.

What now? The money stock overshoot has reversed. The first excess money measure has recovered to zero but the second remains significantly negative. Mixed readings have been associated with equities underperforming deposits on average historically, with some examples of significant losses. Caution still appears warranted.

An obvious suggestion based on the economic scenario described above is to overweight defensive sectors. Non-tech cyclical sectors gave back some of their outperformance in Q2 but are still relatively expensive by historical standards, apparently discounting PMI strength – chart 9.

Chart 9

Accelerated monetary policy easing could be favourable for EM equities, especially if associated with a weaker US dollar. Monetary indicators are promising. EM equities have outperformed historically when real narrow money growth has been higher in the E7 than the G7 and the first global excess money measure has been positive – chart 10. The former condition remains in place and the second is borderline.

Chart 10

Eurozone money trends remain too weak to support an economic recovery. A relapse in the latest business surveys could mark the start of a “double dip”.

Three-month rates of change of narrow and broad money – as measured by non-financial M1 and M3 – were zero and 3.3% annualised respectively in May. Current readings are well up on a year ago but significantly short of pre-pandemic averages – see chart 1.

Chart 1

May month-on-month changes were soft, with narrow money contracting by 0.1% and growth of the broad measure slowing to 0.1%.

Six-month real narrow money momentum – the “best” monetary leading indicator of economic direction – moved sideways in May, remaining significantly negative and lower than in other major economies. (The latest UK reading is for April.)

Chart 2

June declines in Eurozone PMIs and German Ifo expectations may represent a realignment with negative monetary trends following a temporary overshoot – chart 3. A recent correction in cyclical equity market sectors could extend if Ifo expectations stall at the current level – chart 4.

Chart 3

Chart 4

Growth of bank deposits is similar in France, Germany and Spain but lagging in Italy – chart 5. The country numbers warrant heightened scrutiny, given a risk that French political turmoil triggers deposit flight to Germany.

Chart 5

A recovery in the OECD’s US composite leading indicator could be reversing, in which case recent underperformance of cyclical equity market sectors versus defensives could extend.

The OECD indicator receives less attention than the Conference Board US leading economic index but its historical performance compares favourably.

The correlation coefficient of six-month rates of change is maximised with a two-month lag on the OECD indicator, i.e. the OECD measure slightly leads the Conference Board index.

The OECD indicator recovered from early 2023, signalling that recession risk was (temporarily?) receding. The Conference Board index continued to weaken, although the rate of decline slowed.

The latest published numbers show the OECD measure still rising in May. New information, however, is available for four of the seven components. An updated calculation suggests that the indicator peaked in April, with small declines in May and June – see chart 1.

Chart 1

A firmer indication will be available at the end of next week, following release of data on the remaining three components – durable goods orders, the ISM manufacturing PMI and manufacturing average weekly hours.

The suggested stall in the OECD leading indicator recovery has coincided with larger month-on-month declines in the Conference Board measure in April and May.

The price relative of MSCI World cyclical sectors, excluding tech, versus defensive sectors has mirrored movements in the OECD US leading indicator historically – chart 2. A rally in the relative peaked in late March, consistent with the suggestion of an April leading indicator top.

Chart 2