A prior post drew attention to a sharp increase in the US and Eurozone monetary base – currency plus bank reserves – during the first half of May, suggesting that this would contribute to a short-term rally in equity markets and other risk assets. This rise, however, has been partially reversed over the last fortnight – see first chart.

Lows in the US monetary base have preceded US equity market troughs by between two and four weeks since early 2009 – see earlier post. The base bottomed in the week to 5th May while the lowest close for share prices during the recent decline was on 26th May. The base was still 2.7% above its early May trough in the week to Wednesday.

Recent developments echo June / July 2009. The US monetary base fell back after an initial recovery but equities continued to rally strongly – first chart. This may have reflected offsetting stimulus from a large increase in the Eurozone base in late June, resulting from a 12-month ECB lending operation.

The Eurozone monetary base has again risen by more than its US counterpart in recent weeks, though by less than in June 2009. The ECB has curbed the increase by issuing one-week deposits to sterilise the impact of bond purchases under its securities markets programme. Banks, however, are likely to regard these deposits as a close substitute for reserves. An expanded monetary base definition including term deposits has risen by 9.6% since late April.

Measures of equity market sentiment, meanwhile, have recovered from oversold extremes as prices have rallied but are not yet signalling exuberance. The 10-day moving average of the CBOE put / call ratio, for example, remains above levels reached before recent short-term market peaks – second chart.

The current rally, therefore, may have further to run but is likely to face increasing headwinds unless monetary base expansion resumes. The wider macroliquidity backdrop, moreover, remains cautionary, with global real narrow money, M1, growing more slowly than industrial output, suggesting insufficient monetary fuel to power sustained market strength.

The ECB was forced to step up its support for Greece during April as the run on the country's banking system gathered pace.

The Bank of Greece has yet to release full statistics on its website but its monthly financial statement shows lending to credit institutions of €84.8 billion at the end of April, up from €67.0 billion in March. The increase of €17.8 billion represents an acceleration from gains of €7.2 billion in March and €12.5 billion in February – see chart.

ECB / Bank of Greece lending of €84.8 billion is the equivalent of 17% of the assets of the Greek banking system at the end of March, the latest available month. It exceeds the ECB's capital and reserves of €77.3 billion, according to its latest weekly statement.

The ECB has acquired an additional exposure to Greece of €25 billion via purchases of government bonds under its securities markets programme, according to press reports.

National central bank statements show little change in ECB lending to banks in Ireland, Italy, Portugal and Spain during April, suggesting that a Greece-style run has yet to develop in these economies. The largest increase was in Portugal, where Banco de Portugal lending to domestic banks rose from €16.1 billion to €18.4 billion.

Foreign investors continued to buy gilts and Treasury bills on a large scale in April, probably reflecting a flight of capital from the Eurozone as its sovereign debt crisis reached a crescendo. Gilt and bill purchases were £13.1 billion and £1.3 billion respectively versus £14.2 billion and £4.4 billion in March. Total buying was a record £42.1 billion in the three months to April – almost sufficient to finance a public sector net cash requirement of £42.6 billion.

Other features of the April monetary data include:

• Broad money, M4, rose by a further 0.3%, pushing three-month annualised growth up to 6.6% versus just 0.2% in January. This acceleration defies pessimists who claimed that M4 would contract when the Bank of England stopped gilt purchases. (M4 here refers to the Bank's preferred measure excluding money holdings of non-bank financial intermediaries.)

• Banks and building societies have partially compensated for the end of official buying, purchasing £6.3 billion of gilts in April and £13.5 billion in the latest three months.

• While the M4 pick-up is welcome, the sectoral breakdown is less encouraging, showing money holdings of non-financial corporations falling over the last three months. The corporate liquidity ratio, nevertheless, has recovered significantly since early 2009, supporting expectations of a revival in business investment and hiring – second chart.

• Narrow money trends, also, are slightly disappointing, with M1 expansion slowing to 2.7% annualised in the latest three months. Annual growth of 4.8% is much lower than in the Eurozone – 10.7%.

• M4 lending to households remains sluggish while non-financial corporations continue to repay bank borrowing, reflecting their strong net free cash flow surplus. Weakness in credit demand, however, could be starting to abate – the stock of unused facilities granted by banks rose slightly in the three months to April.

Monetary trends, overall, remain consistent with solid economic growth and may not prevent a continued inflation overshoot – the non-inflationary rate of broad money expansion has probably fallen well below historical norms as the demand to hold money has been depressed by negative real interest rates.

Dollar industrial commodity prices fell by 8% during May but are still up by 15% from six months ago, as measured by the Journal of Commerce index, covering 18 materials used in manufacturing production including crude oil and natural gas.

The six-month rate of change of commodity prices continues to correlate closely with that of industrial output in seven large emerging economies (the "E7") – see first chart. This relationship suggests that 1) the recovery in commodity prices since early 2009 has been driven by "fundamentals" rather than speculation and 2) prices will rise further unless E7 six-month output growth slows to below about 3%, or 6% annualised.

Such an output slowdown, meanwhile, is unlikely while E7 real narrow money, M1, continues to expand strongly – second chart.

Monetary pessimists on Eurozone economic prospects cite recent weakness in broad money, M3 – down by 0.1% in the year to April. A detailed examination of the data, however, suggests that monetary conditions are consistent with an ongoing economic recovery and little risk of Eurozone-wide deflation:

• M3 has been depressed by a shift of funds into longer-term bank instruments – deposits with agreed maturity of over two years or subject to notice of over three months and securities of over two years' maturity. These instruments are excluded from M3 but would be captured by the UK's M4 definition, which includes all sterling deposits together with securities of up to five years' original maturity. A Eurozone M4-type measure rose by 1.7% in the year to April, above the latest annual growth rate of UK M4 of 1.2% (in March) – see first chart. (UK M4 here refers to the Bank of England's preferred definition, excluding money holdings of non-bank financial intermediaries.)

• M3 and M4 have picked up recently, rising by 3.3% and 2.9% annualised respectively in the latest three months.

• As in other major economies, with the exception of Japan, broad money demand of households and financial institutions has been reduced by negative real interest rates, so slow overall expansion has not prevented a strong recovery in corporate money holdings – M3 deposits of non-financial corporations rose by 6.1% in the year to April. With firms continuing to repay bank debt, one measure of the liquidity ratio (i.e. corporate M3 deposits divided by bank loans of up to five years' maturity) is at a record high – second chart.

• Narrow money M1 – comprising currency and overnight deposits – has been a better leading indicator of the economy than M3 historically and should be less affected by the recent shift in demand. It is still growing strongly – by 10.7% in the year to April and 9.8% annualised in the latest three months.