Japanese money supply growth has been firming gradually, partly reflecting the already-significant QE programme introduced by the previous Bank of Japan (BoJ) leadership. This trend continued for the broader measures in March but the six-month rate of expansion of narrow money M1 fell back – see first chart. Monetary trends remain consistent with an improving economy but have yet to suggest any step change in prospects.

Global markets have risen since last week’s BoJ announcement of additional easing as speculative investors have “front-run” an expected “wall of money” leaving Japan in a desperate search for yield and inflation protection. The latest weekly capital flow numbers, however, show continued Japanese net selling of foreign bonds, although this may reflect seasonal factors – second chart.

Chinese monetary statistics for March were moderately encouraging, showing rises in six-month growth of the key real money and lending measures – third chart. Real M1 expansion remains slightly below its long-run average but may climb further in April / May – base effects are favourable. Economic prospects, in other words, may be improving modestly.

Korean industry is a bellwether of the global cycle and manufacturers became notably more optimistic about export prospects in March, despite a recent yen-driven surge in the won effective exchange rate – fourth chart. Korean export expectations usually track the G7 manufacturing purchasing managers’ survey – a small decline in the new orders component of the survey last month may be reversed in April.

Monetary trends and leading indicators continue to suggest that global industrial output expansion will moderate from a peak to be reached in the second quarter of 2013. These forecasting measures have yet to warn of serious economic weakness.

The chart shows six-month growth rates of global industrial output and real narrow money together with a leading indicator derived from OECD data*. Real money growth and the leading indicator typically signal economic changes about half a year in advance. The latest data points in the chart are for February 2013.

Output expansion has recovered in early 2013, consistent with a pick-up in real money growth and the leading indicator from spring 2012. The real money measure, however, peaked in October 2012, falling modestly through February 2013. This downshift has been confirmed by a decline in the leading indicator since December 2012. Allowing for the half-year lead, these developments suggest that output expansion will reach a peak between April and June 2013 and moderate over the summer.

Real money growth and the leading indicator are currently still at respectable levels by historical standards. Monetary trends, however, bear close scrutiny – US weekly data suggest a sharp slowdown in March, which will pull down the global real money measure barring an offsetting rise in other countries.

Global economic slowdowns in 2011 and 2012 were associated with significant falls in equities and other “risk” assets. Liquidity support, however, may be greater now than then – real money growth remains above output expansion, suggesting that there is “excess” liquidity available to flow into markets, while ongoing US and Japanese QE programmes will provide additional policy stimulus.

*”Global” = Group of Seven (G7) major countries plus seven large emerging economies (the “E7”). The leading indicator is termed a “double-lead” measure because it is designed to provide earlier warning of cyclical turning points.

A post last week suggested that the Bank of Japan’s monetary blitz would boost the M3 broad money supply by less than 3% in 2013. Further analysis supports this conclusion.

Central bank bond purchases have a direct impact on broad money only if securities are purchased from domestic non-banks – their bank deposits swell as the transaction is settled.

When the central bank buys from the banking system, the banks swap securities on their balance sheet for reserves at the central bank. The money supply is unchanged unless the rise in reserves leads banks to increase lending or undertake other money-creating activities. Any impact, in other words, is indirect.

Buying from overseas investors also has no first-round impact since their bank deposits are excluded from the money supply.

A significant direct boost from the current programme, therefore, depends on BoJ purchases substituting for buying by non-banks. The distribution of holdings and recent behaviour, however, suggest that banks and foreigners will accommodate increased BoJ demand.

The table below is a simplified presentation of data from the BoJ’s flow of funds accounts, showing flows and stocks of government securities by sector. Note, first, that domestic non-banks accounted for 42% of the stock of securities held outside the BoJ at the end of 2012* (right-hand column). The share of the banking sector – comprising Japan Post, domestic banks and other private intermediaries – was higher, at 48%.

These shares imply that, if the BoJ buys from sectors in proportion to their existing holdings, the ¥51 trillion of purchases planned for 2013 will give a direct monetary boost of ¥21 trillion (i.e. 42% of ¥51 trillion). ¥21 trillion is equivalent to 1.9% of the M3 money stock.

Now consider changes in sectoral flows between 2010 and 2012. BoJ buying increased significantly between the two years, from ¥5 trillion to ¥24 trillion. Yet purchases by domestic non-banks fell only marginally, from ¥17 trillion to ¥15 trillion. The BoJ’s increased buying was more than offset by a slump in banking system demand (i.e. including Japan Post), from  ¥26 trillion in 2010 to -¥4 trillion last year.

One explanation for the negative correlation between BoJ and banking system transactions is that banks vary their government securities holdings to offset changes in central bank reserves. BoJ buying boosts bank reserves even when purchases are from non-banks or foreigners. If banks target stable overall liquidity, defined as reserves plus government securities, a rise in their BoJ deposits will automatically trigger a rundown of securities holdings.

A negative correlation between reserves and banking system transactions in government securities is also evident in the UK in recent years and is the basis for the view here that QE pass-through may have been as low as 20% rather than the 60% claimed by the Bank of England – see previous post.

As shown in the table, the BoJ is targeting government securities purchases of ¥51 trillion and ¥50 trillion respectively in 2013 and 2014 but current BoJ deposits are projected to rise by even more, i.e. ¥60 trillion and ¥68 trillion. This huge reserves boost is likely to trigger heavy bank sales of securities. The illustrative forecast in the table shows sales rising from ¥4 trillion in 2012 to ¥27 trillion per annum – smaller than the swing between 2010 and 2012 despite a much larger increase in reserves expansion. With overseas holdings and overall issuance assumed, conservatively, to be stable, this would allow domestic non-bank buying to continue at its recent pace.

On plausible assumptions, in other words, the direct monetary boost from the BoJ’s actions could prove miniscule. A significant overall effect depends on banks and foreigners deploying cash received from the BoJ to increase lending to or buy assets from the rest of the economy. The hope is that, by changing expectations, the policy shift will induce such behaviour but Japan’s prior QE experiment as well as recent US and UK experience argue for caution.

Japan’s economic outlook has improved but this trend was in place before last week’s “shock and awe”, which may have only a marginal further impact and has been pushed through at the cost of the BoJ’s independence, increasing the risk of its future use as a source of permanent monetary deficit financing.

*This compares with a share of domestic non-banks in UK gilt holdings of 61% at end-2008 before QE started in March 2009.

Solid equity market performance during the first quarter reflected a recovery in global economic growth coupled with a supportive liquidity backdrop. Markets may be choppier into mid-year as economic momentum moderates but the liquidity indicators monitored here remain favourable, suggesting limited downside.

The revival in global growth following significant weakness in mid-2012 was foreshadowed by faster real narrow money supply expansion from last spring – real monetary trends lead the economy by about six months, according to the “monetarist” forecasting rule. Six-month global real narrow money growth, however, peaked in October 2012 and has continued to slow in early 2013 – see first chart. Allowing for the half-year lead, this suggests that economic momentum will start to fade again in mid-2013.

Global real money growth slowed in a similar fashion in early 2011 and early 2012 and equity markets subsequently corrected lower on both occasions. The 2011 decline, however, was more severe, with the MSCI World index falling by 23% in US dollar terms from peak to trough versus 13% in 2012, despite more significant economic weakness in the latter year. The likely explanation is that the liquidity backdrop was unfavourable in 2011 but supportive in 2012 – the gap between global real money growth and industrial output expansion was significantly negative for several months in early 2011 but remained mostly positive in early 2012.

Any coming equity market set-back may resemble the mild 2012 correction. First, global real money expansion remains respectable by historical standards – it is not, in other words, signalling major economic weakness. Secondly, the real money / industrial output growth gap has yet to close as it did in 2011 and 2012. Thirdly, the Federal Reserve and Bank of Japan (BoJ) are committed to further substantial liquidity injections – the market decline of 2011 may also have been influenced by the ending of US QE2 in June of that year.

The latter point is illustrated by the second chart, showing commercial banks’ holdings of cash at the Fed, BoJ and ECB along with projections based on announced US and Japanese QE plans. Combined reserves fell during the first quarter as Eurozone banks repaid borrowings from the ECB but US / Japanese liquidity injections should now dominate, resulting a new record being reached by mid-year.

Some analysts speculate that equities will receive additional “structural” support from a “great rotation” out of bonds but, even if true, this is probably of limited relevance for the near-term outlook. Retail buying of equities has picked up in early 2013 but inflows to bond funds have remained solid – any “rotation”, in other words, has been out of cash. Equity market outperformance reduces pension fund deficits and may, perversely, encourage more buying of bonds as liability matching becomes feasible.

Japan, Switzerland and the US were the best-performing markets in currency-adjusted terms during the first quarter, while the Eurozone periphery was again weak, along with emerging markets. This was similar to the ranking of real money growth at the start of the year – the US and Switzerland were then at the top, with the periphery at the bottom and emerging markets below the average. Japan’s outperformance partly reflected expectations of additional monetary policy easing in early April under the newly-installed BoJ leadership.

A key monetary development recently has been a sharp fall in US real narrow money growth – third chart. With Fed policy remaining expansionary, this was unexpected: it may partly reflect the removal of unlimited insurance of demand deposits at the start of the year but could also indicate a reining back of spending plans, perhaps in response to fiscal tightening. The size of the move argues against downplaying it – US economic performance may disappoint during the second half, with US equities underperforming.

Another notable change is that real money has resumed growth recently in the Eurozone periphery, led by Italy, although the rate of expansion is below the global average. The latest number predates the imposition of losses on Cypriot bank depositors, which could trigger renewed capital outflows, although this is not yet suggested by weekly ECB balance sheet data. Assuming no relapse, monetary trends suggest raising equity exposure while remaining underweight.

UK real money growth has also improved absolutely and relatively, despite the suspension of QE last November. Corporate liquidity is particularly strong – fourth chart. Institutional selling of UK equities, meanwhile, has abated: domestic institutions in aggregate were net buyers in the fourth quarter for the first time since 2010. These developments appear to support a higher UK weighting.

Japanese equities have been impressed by “shock and awe” BoJ easing but this has yet to be reflected in a pick-up in real money growth, which is in the middle of the global pack. The rally to date has been led by foreign buying – not usually a good sign – and some caution may be warranted pending either a relative correction or confirmation of monetary improvement.

Elsewhere, monetary trends remain favourable in Switzerland and Germany, with the latter dragging up the Eurozone core despite weakness in France and a slowdown in the Netherlands. Combined real money growth in the “E7” large emerging countries, meanwhile, is improving relative to the G7 as the latter slows, warranting consideration of an increased weighting, particularly following recent underperformance.