We have all seen it countless times before: visual confirmation that without the Fed’s (and all other central banks’) liquidity pump, the S&P would be about 70% lower than were it is now.
Most recently, this was shown last Friday in “Another Reminder How Addicted Markets Still Are To Liquidity” in which Deutsche bank’s Jim Reid said:
The recovery from the lows after Bullard spoke yesterday is another reminder how addicted markets still are to liquidity. Indeed in today’s pdf we reprint and update a table from our 2014 Outlook showing the various phases of the Fed’s balance sheet expansion and pausing over the last 5-6 years and its impact on equities and credit. We have found that the relationship broadly works best with markets pricing in the Fed balance sheet move just under 3 months in advance. We’ve also included our oft-used chart of the Fed balance sheet vs the S&P 500 to help demonstrate this. So end July / early August 2014 was always the time that this relationship suggested markets should enter a new more difficult phase. So we still think central bankers hold the key to markets going forward and there seems to be a hint of change in the Fed.
So now that “best Keynesian practices” are out of the window, and everyone has once again turned Austrian, and only the “flow of money” (either inside or outside) matters, the question is how much do central banks need to inject to keep the stock market from crashing, let alone continuing to levitate. Luckily, Citi’s Matt King has just done the math, and the answer is…
Here is his answer:
We think the markets’ weakness owes more to an almost belated reaction to a temporary lull in central bank stimulus than it does to any reduction in the effect of that stimulus in propping up asset prices. Figure 5 shows the rolling 3m combined liquidity injection by the Fed, the ECB, the BoE and the BoJ, plotted against the rolling 3m change in spreads. While the relationship is not perfect – liquidity flows across asset classes and across borders, and there are announcement and confidence effects in addition to the straightforward impact on net supply – it is this, not fundamentals, which we would argue has been the major driver of markets for the past few years (Figure 6 shows the same series plotted against global equities).
In case anyone missed it, and in case there is still any debate about this issue which we first explicitly stated nearly 6 years ago and were widely mocked by the all too serious intelligentsia, here is the key sentence again:
“it’s the liquidity injections, not fundamentals, which we would argue has been the major driver of markets for the past few years.“
And with that piece of New Normal trivia behind us, we continue:
For over a year now, central banks have quietly being reducing their support. As Figure 7 shows, much of this is down to the Fed, but the contraction in the ECB’s balance sheet has also been significant. Seen from this perspective, a negative reaction in markets was long overdue: very roughly, the charts suggest that zero stimulus would be consistent with 50bp widening in investment grade, or a little over a ten percent quarterly drop in equities.Put differently, it takes around $200bn per quarter just to keep markets from selling off.