Most investors recognize that central banks are a key driver in the ebb and flow of equity prices through time. But the relationship between interest rates, monetary policy and the stock market is constantly evolving. Some analysts advise that in recent years this link has become unusually influential. As we’ll see, that’s a theory that finds support in the data.
As a general proposition, the connection between stocks and monetary policy is hardly mysterious. One of Wall Street’s favorite maxim’s captures this relationship: Don’t fight the Fed. The reasoning is that when the Federal Reserve is easing monetary policy and injecting liquidity into the economy, some (perhaps a lot) of the newly minted money sloshing around finds its way into the stock market and drives up prices. The opposite is true when tighter policy prevails.
But while this basic relationship is generally accurate, the degree of influence varies through time, sometimes dramatically. The stock market is forever discounting numerous variables at any point. But the influence of any single variable is constantly changing, based on the news cycle, economic conditions and countless other factors.
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The question is whether monetary policy has been an unusually large factor in the stock market in recent years? In particular, has the Fed’s atypically aggressive policy-easing efforts following the 2008 financial crisis cast an uncommonly bullish influence on equities? It appears so, based on analysis of money supply and the Russell 3000 Index, a broad measure of the US stock market.
Money supply here is defined as the real (inflation-adjusted) one-year change in M0 (also known as base money or high-powered money). For comparison with the Russell 3000, the data are scaled (based on z-scores) for easier visual comparison. In the first chart below, the historical record for one-year changes since 1979 looks like noise overall. Sometimes there’s a positive relationship, sometimes negative, and quite often there’s no discernible pattern.
Running a correlation analysis on the full sample in the chart above via the raw numbers reveals a mildly negative reading: roughly -0.26. That’s close enough to zero to conclude that there’s no obvious relationship between the data sets over the four decades.
But a different picture emerges when we restrict the analysis to the post-crisis period starting in 2010. By that standard, the data strongly suggests that there’s a much stronger connection between monetary policy and one-year equity returns, as shown in the next chart below.
Although the connection isn’t perfect, there appears to be a closer link between the ebb and flow of one-year changes in stocks and the trend in M0 money supply since 2010. As liquidity growth rises and falls, equities tend to follow via rolling one-year results.
Indeed, the correlation between the one-year changes for M0 and the Russell 3000 since 2010 is a moderately positive 0.47. That’s still well below a perfect positive correlation of 1.0, but it’s relatively high vs. the longer-run history and it tells us that something’s changed, namely: monetary policy’s influence on stock prices has increased sharply in recent years.
In time, it’s likely that the Fed’s influence on stocks will fade. At the moment, however, it’s not obvious that we’ve reached that transition phase. In fact, recent history suggests that shifting expectations in Fed policy remain a potent driver of stock prices. Indeed, this week’s upwardly revised estimates that an interest-rate cut is near has reportedly been a key driver of the equity market’s rally over the past several days.
Keep in mind, however, that the broader trend in monetary policy has reflected a bias for tightening. Consider M0’s trend in recent years. As the third chart below reminds, M0’s real one-year changes have been negative for more than a year. In turn, that suggests that stocks continue to face headwinds via monetary policy. No surprise, then, that the one-year trend for equities has been fading.
The Russell 3000’s one-year change is still positive, albeit at a modest 3.4%, based on the trailing 252-trading-day period through yesterday’s close (June 6). But that’s down from the previous peak — a roughly 10% gain in April and as much as 20% as recently as last August.
Perhaps the lesson is that unless and until monetary policy makes a sharp U-turn and delivers a new round of stimulus, the stock market’s outlook remains challenged.
Then again, no one will ring a bell when monetary policy’s outsized role in driving stock prices wanes and transitions to something approximating its pre-2008 profile.
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