Finance: The return of liquidity and risky assets?

Stock market indices have been gradually accumulating new highs since the start of the year. The resilience of the US economy has restored some confidence to investors. Moreover, there is a feeling of already seen compared to more risky stocks, and in particular with the arrival of more liquidity. We are going to look together at the factors that can influence the return of risky assets.

The US economy, a primary source of liquidity

The US surprised us with its ability to weather the rate hike between 2022 and 2023. The job market has remained quite resilient. And this, probably thanks to the fact that it was necessary to put in order the imbalances resulting from the COVID crisis. We are talking here about the labor shortage after the pandemic. These elements have made it possible to maintain a competitive job market. And at the same time, the process of disinflation was a relief for households to regain confidence. This also ended up having repercussions on the markets. For example, here is the improvement in consumer sentiment:

The disinflation process probably comes from the fact that China has gone through a major deflationary crisis. This has allowed the US to import deflation at least since 2023, allowing the US to avoid a recession. Here is an illustration of this:

The decisions of the FED (American central bank), a key factor

Since 2022, decisions coming from FED members have had an impact on the markets. They have been making rain and shine for 2 years. Each speech is carefully listened to in order to demystify whether the directives will be more accommodating or restrictive. It was agreed that it would slow down the pace of balance sheet reduction at the FED's last FOMC meeting. This means that since the start of the implementation of restrictive monetary policy, the FED has not renewed the maturities of the bonds it holds in its portfolio. This therefore reduces available liquidity. Here is an example of the reduction in the balance sheet since 2022:

However, it was specified that the FED will reduce the rate of reduction of the balance sheet from 60B to 35B. Even if reducing the balance sheet remains a restrictive principle, reducing the pace is seen as a kind of relief. Therefore, markets interpret this as better financial conditions and move towards ATHs (higher).

In another register, we can look at the net liquidity of the FED which takes into account both the balance sheet, the repo market and the treasury account. We can see that this has been improving since the end of 2022, which also coincides with the bottom of the US markets.

Calculated and well-timed interventions

In parallel with the latest changes that were made by the American central bank, there were other speakers such as that of Treasury Secretary Yellen. At the same time, a repurchase of US bonds was announced for the coming months in order to ease the tensions surrounding high US debt. A repurchase or buyback in English is a process of repurchasing securities in order to reduce the available supply. This program is being introduced for the first time in 20 years. The very objective is to reduce the volatility and tensions which have mainly come from the bond market over the last two years. You could say it's to support liquidity. It is also for one of these reasons that we can see that the volatility index on the bond market has relaxed quite a bit in recent weeks.

And along the same lines and during the same period, we had a synchronized intervention from the Bank of Japan when the USDJPY tagged the 160 level. Japan is one of the largest holders of US bonds. This is why synchronized interventions between the different central banks are important.

The impact of liquidity on assets

The growth of the M2 money supply has returned to the positive zone, which has not happened for around a year and a half. Typically, this can also be a sign of robust economic growth ahead. Liquidity leads risky assets.

For example, bitcoin is one of the assets that is highly correlated with the money supply. A contraction or reduction in the money supply is often negative for bitcoin and vice versa. This process is rather logical because the money supply represents the monetary supply and this is unlimited. This principle is the opposite of bitcoin, the supply of which is limited to 21 million. On the other hand, the bitcoin production process is reduced every 4 years, this is called halving. As the inflation rate of bitcoin decreases over the years, this is also why bitcoin reacts positively to an increase in the money supply.

Is the euphoria of risk assets back?

One of the consequences of an increase in liquidity is obviously euphoria on risk assets. This is particularly the case with meme-stocks for example (actions that gain popularity on the media or social networks). We could see this with the euphoric return of the GAMESTOP and AMC titles which marked 2021. A quick reminder, the story of Gamestop highlights how a group of beginner investors (dumb money) bet against the money coming from huge investment companies (smart money) to bring them down. Here is precisely the performance of GAMESTOP after a simple tweet from the protagonist of this story, Roaring kitty, a few days ago:

When liquidity is plentiful, euphoria comes to the markets. And this money is transferred a little to everything that moves. Therefore, this may also be the case this year since we have both the liquidity that is present and early signs on the return of meme-stocks.

For example, after the GAMESTOP and AMC affair in 2021, the euphoria transferred to the altcoin market whose memecoins. Here is a graph highlighting GME in orange and altcoins, we can see this transfer:

This is why liquidity can be a harbinger of euphoria in markets where assets are more at risk.

CONCLUSION

There are several elements which point to an improvement in liquidity for the coming months. This can lead to both a melt-up (bullish) in the financial markets and also give a surge of euphoria on riskier assets. Obviously, this type of situation does not always end well, so you have to be careful in this type of situation.