An April post argued that Japan’s expanded QE would have a smaller positive impact on monetary conditions and the economy than many believed, because official bond purchases were likely to be offset by stepped-up selling by banks – such sales reduce the broad money supply and put upward pressure on short-maturity yields.

Consistent with this view, domestically licensed banks reduced their central government bond holdings by a monthly record ¥10.5 trillion in April, outweighing a rise of ¥8.7 trillion on the BoJ’s books. The fall is equivalent to 21% of planned official JGB purchases for the whole of 2013 (i.e. ¥51 trillion).

The impotence of QE in Japan and elsewhere is a consequence of banks targeting a fixed level of overall liquidity, i.e. central bank reserves plus government bonds. QE forces banks to hold more reserves, causing a reduction in their demand for bonds. The BoJ plans to inject ¥60 trillion of reserves this year so banks should continue to run down their holdings – ¥156 trillion at end-April – to prevent their overall liquidity from ballooning.

Japan’s economy is expected here to grow moderately through late 2013, a forecast consistent with recent unexceptional real M1 expansion – see Tuesday’s post. Nominal M1 trends need to strengthen significantly over the next 12 months if real growth is to remain consistent with economic recovery, assuming that the government implements the planned 2014 sales tax rise – expected to boost inflation by about 2 percentage points.

A longer leading indicator of global industrial output growth rose slightly in April, breaking a five-month sequence of declines. This confirms a positive message from real narrow money supply expansion and suggests that the global economy will grow solidly through late 2013.

The first chart below shows a short-term leading indicator of global industrial activity based on OECD country leading index data together with a transformed measure designed to provide a longer lead at cycle turning points. This longer-term or “double-lead” indicator has signalled peaks and troughs in output growth an average of five months in advance in recent years versus three months for the short-term measure.

The double-lead indicator peaked in October 2012, declining modestly through March 2013. This downshift has been confirmed by an easing of the short-term measure since January. The behaviour of the indicators has been consistent with the long-standing forecast here that global industrial expansion would peak in spring 2013 and moderate over the summer.

The April rise in the double-lead measure, however, suggests that this slowdown will be modest and growth will pick up again from September. Monetary trends are giving the same message: global real narrow money expansion also reversed a five-month decline in April and is running at a level historically consistent with robust economic growth – second chart.

Markets looked vulnerable to a correction but current weakness may be temporary and limited, based on the favourable economic / liquidity assessment here.

In other news today, Japanese six-month real narrow money M1 expansion rose slightly in May but remains unexceptional by historical standards and relative to other countries – third chart. This suggests that QE has yet to gain significant traction, warranting caution on relative equity market prospects.

The Chinese economy remains sluggish but prospects may be improving slightly.

Six-month growth in industrial output is estimated* at 3.4% in May (i.e. 6.9% annualised), little changed from April’s 3.3%, which was the lowest since August 2012.

Economic weakness, however, has not been confirmed by monetary trends. Six-month growth in real narrow money M1 was 4.7% in May, in line with the recent average and historically consistent with a faster pace of industrial output expansion – see first chart. The broader real M2 aggregate is giving a more positive message, with a six-month May rise of 6.9%.

Pessimists are focusing on slower growth in bank loans and the broader “total social financing” credit measure. This, however, may be partly a reflection of recent softness in activity rather than a pointer to prospects – credit is usually a coincident or lagging economic indicator, while the money supply leads. Real loan / credit growth, in any case, remains solid – second chart.

The suggestion that economic momentum will revive near term is supported by a notable rise in the “official” manufacturing purchasing managers’ new orders index, adjusted for seasonals**, in May – third chart. This contrasts with a fall in the equivalent Markit measure but the official survey has been more reliable historically (i.e. divergences have usually been resolved by the Markit index moving in the direction of the official series rather than vice versa).

The recent fall in six-month industrial output growth below real M1 as well as M2 expansion suggests an improving liquidity backdrop for Chinese markets, assuming no change in monetary policy.

*All growth rates quoted here are based on monthly break-adjusted levels series estimated from official data and incorporating a seasonal adjustment.
**The official series is labelled as seasonally adjusted but displays a pronounced seasonal pattern.