The current market rally is mostly due to increase in money supply
Supply of money in circulation is defined in different ways, such as M1 and M2. According to Investopedia, “M1 is the money supply that is composed of physical currency and coin, demand deposits, travelers’ checks, other checkable deposits, and negotiable order of withdrawal (NOW) accounts. M1 includes the most liquid portions of the money supply because it contains currency and assets that either are or can be quickly converted to, cash.”
In other words, M1 money supply is a direct indicator of how liquid financial market is, as it represents the most liquid form of money circulating the market. It is also directly related to stock and bond market, as more money in circulation means that people have more money to buy financial assets in the market.
Let us have a look at what has happened to M1 money supply and the NASDAQ Index since the Global Financial Crisis in 2007.
Source: Board of Governors of the Federal Reserve System, Capital IQ
Note: M1 Money Stock is defined in Billions of Dollars, Weekly, Seasonally Adjusted
As of July 2020, there is $5.3 billion amount in M1 money supply, which is four times the amount in January 2007 when there was only $1.4 billion. In the meantime, the NASDAQ Index has increased from 2,438 to 10,000, roughly showing the same four times increase.
This also shows approximately 95% correlation between M1 money supply and the NASDAQ Index.
What do these graphs tell us? They tell us that:
1) The quantitative easing by the FED in 2008 to deal with the Global Financial Crisis pales in magnitude in comparison to that of the FED to deal with COVID-10 in 2020.
2) If you are interested in predicting the movement of the stock market, then predicting the money supply is one way of doing it.
3) Since 2017, the increase in the stock price has outpaced the increase in money supply. It is only when the FED stepped in and began unlimited purchasing of assets to deal with COVID-19 that the stock market and M1 money supply began to overlap again.
4) Once the FED stops or reduces the quantitative easing and thus reduce M1 money supply, either because it ran out of ammunition or thinks that the effects of COVID-19 have subdued, then the stock market may face another difficulty.
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