In a Wall Street Journal article in July 2009, Andy Kessler drew attention to a remarkable correlation that had developed between US stocks and the monetary base (i.e. currency in circulation plus bank reserves). Kessler suggested that the market had become dependent on “Mr. Bernanke’s magic dollar dust”.

The Fed’s liquidity operations have continued to influence stocks over the subsequent two and a half years, judging from the chart, showing the Dow Industrials index and bank reserves, which now dominate the monetary base.

Until mid 2010, reserve movements led the market; the sell-off in stocks in the late spring and early summer of that year, for example, was preceded by a contraction in reserves as the Fed ended its QE1 bond-buying operation.

Investors seem then to have cottoned on to the relationship, bidding stocks significantly higher in autumn 2010 after Mr. Bernanke signalled his intention of launching QE2 but ahead of the impact on reserves, which began to surge only from year-end.

In 2011, bank reserves hit a new record in mid-July, just after the end of QE2, with this high roughly coinciding with a secondary peak in stocks before a late summer plunge. The subsequent market recovery has returned the Dow to a level consistent with the modest decline in reserves from their July top.

Bank reserves have risen in each of the last three weeks, with the latest $55 billion increase mainly due to the Fed’s swap lending to the ECB. Another surge is unlikely barring QE3 but reserves could continue to edge higher, either because the swap operation expands further or ECB / Fed backstopping of the European banking system leads to a reduction in foreign official institutions’ precautionary balances at the Fed, thereby releasing liquidity into the market.

G7 bank reserves are being boosted, additionally, by an expansion of ECB lending and UK QE2, and may reach a new record over coming weeks.

Equity markets, therefore, should be underpinned to the extent that central bank liquidity remains a key driver.

Recent UK economic news has been better than feared, consistent with the view here that a recovery in real money expansion would support demand and activity.

Exhibit one is today’s retail sales report, showing a 3.2% annualised rise in volumes in the three months to November from the previous three months – the fastest such growth rate since August 2010.
Retail sales, admittedly, are often a poor guide to overall household spending. Car registrations and house-hunting activity, however, provide supporting evidence of consumer resilience.

Net exports should contribute positively to the current-quarter GDP change, despite Eurozone weakness, judging from the October trade report.

A fall in GDP, therefore, would seem to require a sizeable decline in corporate spending on top of reduced government outlays. Strong corporate liquidity ex. the real estate sector, however, should serve to restrain cut-backs.

Labour market indicators are weakening but not at a pace suggesting economic contraction. Claimant-count unemployment rose by 19,000 in the three months to November versus 36,000 in the three months to May 2008 – the middle month of the first quarter of the last recession. (The claimant measure was boosted between late 2008 and mid 2011 by lone parents moving from income support to the job seekers’ allowance.)

Output expectations in the CBI December industrial survey, meanwhile, recovered to a seasonally-adjusted level of zero, questioning forecasts of an imminent large decline in manufacturing output.

Markets are fretting about a Chinese “hard landing” but – at least to this analyst – incoming news remains reassuring.

Monetary figures released today show a further recovery in the six-month rates of expansion of real money and loans. Earlier weakness in these measures was the basis for a forecast that the economy would slow sharply later in 2011 – see, for example, here.

The revival in real money growth reflects both recent slower inflation and a recovery in nominal expansion.  The six-month increases in real M2 and loans are solid by historical standards, though real M1 is lagging.

Last week’s industrial output numbers – as well as the OECD’s Chinese leading index discussed on Monday – suggest that activity may already be responding to monetary loosening. If so, PMI results for December should reverse November weakness – judged here to be at least partly seasonal in nature.

It is, of course, important that the Chinese authorities sustain the recovery in monetary growth by loosening policy further – warranted by recent evidence that core as well as food price pressures have eased.

Unsurprisingly given Bundesbank opposition and the constraints imposed by its mandate, the ECB last week refrained from launching large-scale country-neutral QE, as warranted by Eurozone-wide monetary weakness and an oncoming recession.

This refusal, however, was counterbalanced by an unexpectedly generous expansion of its banking system support operations, with an increase in the maximum term of subsidised lending to three years accompanied by a significant further loosening of collateral requirements. Sig. Draghi hopes that a massive infusion of cash will discourage banks from liquidating their sovereign bond portfolios and even stimulate renewed purchases, thereby achieving QE by the back door.

This strategy seems to have been successfully employed in 2008-09 – the ECB’s repo lending rose by €350 billion in October 2008, following Lehman’s collapse, while bank purchases of government bonds surged to €315 billion over the subsequent 12 months. The latter amount was the equivalent of 3.4% of the M3 money supply.

Recent losses, heightened default risk and new mark to market requirements suggest that banks will be much more circumspect about expanding their bond portfolios now. The current infusion of liquidity, however, may surpass the 2008-09 increase by a wide margin as banks make full use of the subsidised three-year operations next week and in February. The interest reward for accepting sovereign risk, moreover, is much greater than post Lehman – the spread between the Italian 10-year yield and the ECB’s repo rate was 260 basis points in January 2009 versus a recent peak of 600.

The backdoor QE ploy is sub-optimal and risky but was Sig. Draghi’s best available option and may yet succeed in loosening monetary conditions and limiting the current recession.

The OECD’s leading indices for October, released today, provide further evidence that global economic weakness is abating, consistent with faster real money supply expansion since the spring.

Confirmation of the message from monetary trends is sought here from a global leading indicator derived from OECD country indices covering the G7 and emerging “E7” economies. This indicator bottomed in July and turned positive in October for the first time since March. The July trough follows a May low in six-month real narrow money supply expansion.

The indicator, admittedly, is recovering from a depressed level, suggesting that economic news will remain weak in the short term and that the incipient upswing is vulnerable to negative “shocks”. Changes in trend, however, tend to be sustained and the monetary backdrop is still supportive, with real money expansion likely to be bolstered by a further slowdown in inflation and central bank easing.

The recovery in the indicator initially reflected E7 improvement but the G7 component has revived from a low in August, though remains weak.

The US is doing best within the G7, consistent with monetary developments and a recent pick-up in the ISM manufacturing new orders index.

The Mexican indicator often provides a lead on the US and remained strong in October, suggesting further US improvement.

The Chinese indicator moved sideways in October following a recovery, consistent with industrial growth stabilising at a moderate pace.