At yesterday's close, the Dow Industrials index was 7% below the six-bear average and only 2% above the bottom of the six-bear range – see chart and prior post for background.

The ECB has been at pains to distinguish its securities markets programme (SMP) from US- and UK-style quantitative easing (QE). The differences, in practice, look minor.

Bond buying to date has been on a larger scale than suggested by the stated objective of restoring depth and liquidity to dysfunctional markets. €26.5 billion of securities were purchased in the first seven days (assuming T+3 settlement), equivalent to a weekly rate of €18.9 billion. If this pace were sustained for three months, the ECB would acquire a portfolio of €246 billion, equivalent to 2.6% of Eurozone broad money, M3, and 33% of the outstanding government debt of Greece, Ireland, Portugal and Spain (15% if Italy is also included).

The ECB claims that the SMP will have no impact on monetary conditions because buying will be sterilised. This is oversimplistic. A purchase of bonds from a non-bank investor results in an increase in both the investor's bank account balance, included in the broad money supply, M3, and bank reserves, a component of the monetary base. If the ECB sterilises the purchase by conducting a reserves-draining operation with the banking system, the rise in the monetary base is reversed but not that of M3. (The M3 increase is reversed only if sterilisation involves a sale of assets to the non-bank private sector. Note that M3 is unaffected if the initial purchase is from a bank rather than non-bank.)

While the ECB is sterilising its bond purchases, moreover, it has reverted to supplying unlimited funds in its three- and six-month lending to the banks, in addition to the main one-week repo operation. The monetary base, therefore, is being determined by banks' demand for ECB credit, which has increased as weaker institutions have suffered funding shortfalls. Accordingly, the base has risen by 3.8% in the first two weeks of the SMP and is up by 7.4% since late April.

The ECB's method of sterilisation – auctioning one-week deposits to banks with surplus liquidity – is, in any case, cosmetic. Banks are likely to regard these deposits as a close substitute for reserves. The effectiveness of sterilisation may depend on the length of time reserves are removed from the system, with permanent asset sales having the largest impact.

The SMP, so far at least, appears to pass the QE "duck test". Opposition from Bundesbankers and their ECB allies, however, could yet derail the programme.

As expected, GDP growth in the first quarter was revised up from 0.2% to 0.3%. More importantly, the profile of output over the three months implies a strong starting base for the second quarter.

The chart shows quarterly GDP together with a monthly estimate based on services and industrial production, which have a combined weighting of 93%. After a 0.7% fall in January, partly reflecting weather disruption, monthly GDP rose by 0.6% and 0.7% respectively in February and March. The March reading was 0.6% above the quarter average.

GDP inflation, meanwhile, picked up further last quarter. The deflator for gross value added (GVA) at basic prices – which fully adjusts for the VAT hike and may therefore understate the underlying trend – rose by 1.0%, or 4.0% annualised.

Nominal GVA expansion, therefore, accelerated from 3.6% annualised during the second half of 2009 to 5.1% in the first quarter. Such a growth rate, if sustained, is unlikely to be compatible with the 2% inflation target over the medium term.

The yen, rather than the US dollar, could be the big winner from a loss of confidence in the euro as an international store of value.

More fund managers – a net 51% – believe that the yen is overvalued than any other currency, according to the latest Merrill Lynch global survey. This suggests that they are not positioned for further strength.

The perception that the yen is expensive may reflect its nominal effective (i.e. trade-weighted) exchange rate, which is only 3% below its all-time high reached in January 2008. A correct assessment, however, should be based on the real effective rate, i.e. adjusting for Japan's superior inflation performance. This remains below its long-run average – see first chart.

Relative monetary policies are an influence on currency performance. Real official interest rates (i.e. relative to the annual rate of change of consumer prices) are much higher in Japan than the rest of the G7. The 3.2 percentage point gap with the US is the largest since 1980 – second chart.

The Fed and ECB have responded to market turbulence by expanding the monetary base – see Friday's post. The Bank of Japan has yet to follow – third chart. Fed liquidity injections, if sustained, could limit further US dollar gains, deflecting upward pressure onto the yen.

The US monetary base (currency plus bank reserves) rose again in the week to Wednesday and is now up by 3.7% from its low a fortnight ago, following a 9.4% contraction between late February and early May. A recovery in the monetary base preceded a rally in equities by three weeks in February / March 2009, by two weeks in June / July and by four weeks in January / February this year – see first chart.

The Eurozone monetary base also rose in the week to last Friday and is up 9.7% since late April – first chart.

Some measures of equity market sentiment look extremely oversold. The Chicago Board Options Exchange equity put / call ratio, for example, is at its highest level since the bear market ended last March – second chart.

The sustainability of any rally in equities may depend on whether central banks continue to expand liquidity. The Fed may be reluctant to reverse fully the earlier contraction of the monetary base unless it believes that market turbulence is a serious threat to the economic recovery. The impact on the base of its dollar swap lending to European central banks has so far proved small – the ECB's 84-day tender of dollars this week attracted bids of only $1.0 billion. The ECB, meanwhile, continues to state that it will sterilise the liquidity effect of its "non-standard" measures.

A signal that the Fed was turning more expansionary would be an announcement of a reduction in the "supplementary financing programme", under which the Treasury has issued an additional $200 billion of bills, placing the proceeds in a special account at the central bank. The Treasury could repay maturing bills by running down the balance in this account, thereby boosting bank reserves and the monetary base.

A further reason for caution about any rally is the still-unfavourable balance between global economic and monetary growth. G7 real narrow money, M1, is continuing to expand more slowly than industrial output – third chart.

The fourth chart shows regional equity market performance, including currency, relative to the World index. Europe ex. the UK has underperformed significantly so far this year but the price relative has made higher lows recently, hinting at a turnaround. Extreme investor pessimism about Europe and the euro is already reflected in positioning, while real M1 is growing faster in the Eurozone than in the US, Japan and UK.

The Dow Jones industrial average fell by 54% between October 2007 and March 2009. There were seven declines in the Dow of 45% or more during the last century – see table. Six of the seven were in a range of 45-55%, the exception being the 89% fall between September 1929 and July 1932.

The chart compares the recovery in the Dow from its trough on 9 March 2009 with the rallies following these six prior bear markets, excluding the 1929-32 decline. The low of each bear was rebased and aligned with the March 2009 trough. The chart shows mean performance and the range across these prior falls and recoveries.

The Dow has been mostly ahead of the average since the March low, sometimes even straying above the range spanned by the prior rallies. This may reflect the unprecedented monetary stimulus unleashed by the Federal Reserve and other central banks amid the post-Lehman crisis. Also, the October 2007-March 2009 decline was slightly larger than the average (54% versus 48%), possibly contributing to a stronger recovery.

As the liquidity backdrop has deteriorated, however, the Dow has converged with the six-bear mean, closing marginally below it yesterday.

The average suggests that equity performance over the next year will be much less impressive than during the first 12 months of the rally. The level of the average at the end of June 2011 is 8% above yesterday's Dow close.

The chart, however, also shows that the range of performance during the second year of recoveries has been much wider than in the first. The "best-case" historical scenario would involve the Dow reaching 16,000 early next year. The minimum suggested level is 8,800 – still 34% above the 6,547 low reached last March.

Based on liquidity analysis, a fall into the lower half of the historical range seems more likely in the short term than renewed strength. With economic recovery expected to be sustained into 2011, however, a significant undershoot of the average could present another buying opportunity – especially if current turbulence forces central bank easing.