Financial markets addicted to liquidity

You’ve probably heard this popular phrase before. printing machine” or print money”? It is clear that the financial markets are becoming more and more addicted to the liquidity injected by the FED. It is therefore important to approach the subject and to see the ins and outs.

What does printing money mean?

In order to popularize as well as possible, we will replace certain complicated terms of the financial industry with more common terms or expressions. print money just want say “inject cash in the financial system.

This process is known more technically as the program of the quantitative easing », or QE, of central banks. This consists of buying government bonds, and therefore, this results in more liquidity in the financial system. The reverse principle is quantitative tightening »or QT, which consists of withdrawing liquidity from the financial system. This is currently the case for the Fed.

Buying bonds is supposed to keep bond prices high and therefore keep rates low.

Reminder: bonds and rates vary in opposite ways. If rates go up, the price of the bond goes down and vice versa.

Then the process is quite simple to understand. If rates are low, this will encourage households and businesses to borrow at low cost. This will increase spending and thus stimulate growth. Stimulating growth enables central banks to achieve their inflation target of 2%.

The principle of injecting money into the economy

The principle of injecting money was put in place in 2008 in order to save the economy. Initially, we use the printing press when we no longer have any other means of reviving economic growth. For example, when the Central Bank has already lowered its rates to 0% and this remains insufficient to revive growth, we will call on the printing machine. And if we relaunch economic growth, this will guide the inflation rate towards its target level, ie 2% (especially in the US and Canada).

In order to better understand this process, it should be noted that the economy is stimulated by two major factors, mainly:

  • Demographics ;
  • The debt.

The first demographic factor is becoming increasingly problematic in developed countries. It can be seen that the growth in the number of people of working age is increasingly weak.

In Europe, Japan, and China, we can see negative growth in people of working age, 15 to 64 years old. Only the United States still remain positive, but close to 0% in the forecast.

The case of Japan is well known, they proceeded with unlimited printing to save their bond market despite their currency.

The case of the Central Bank of England

You’ve probably heard recently that the Central Bank of England has revived the money-printing machine? This is normal, this follows liquidity problems in the bond market. Bonds are very popular as an asset class for pension funds (funds for retirement).

The problem here is that initially, the principle of injecting money was designed to push inflation up towards 2%. But you can see that inflation in England is at 9.9%.

The tool that was created to save the economy more than a decade ago is itself becoming problematic, as it also stimulates inflation.

The process gradually becomes the same as in Japan, the markets become addicted to liquidity. Next on the list, the European Central Bank? Most likely.

What about the Fed? Before replacing the money printing machine (quantitative easing/injecting liquidity), maybe the FED will proceed with the QT shutdown (quantitative tightening/withdrawing liquidity) that it has put in place since June 2022. The QT process is the opposite of QE, that is to say that instead of injecting liquidity, we will withdraw it. As the demographic level is still better for the US (not yet negative) than for Europe, Japan or China, they may still have more leeway than the other central banks.

The consequences of the printing press

As we mentioned before, printing money becomes important, because the demographic factor is increasingly weak. However, the financial markets are becoming addicted to liquidity, and this has the consequence of becoming less efficient, since the fluctuations largely depend on it.

Here is an example of the fluctuation of the balance sheet of the FED and the major index of the United States, the S&P 500. You can see that when this increases, the markets go up and when the FED reduces its balance sheet, there is more volatility in the financial markets.

the fed, cash, injections, the fed balance sheet,
Source: Tradingview

Here is another example highlighting the year-over-year growth rate of the S&P 500 index, but also of the M2 money supply.

injections, cash, the fed, junkies
Source: Isabelnet

One of the major consequences of printing money is inflation. When financial conditions are made more accessible by lowering borrowing rates, this encourages consumption, investment and stimulates growth as well as inflation. In this case, to know if the injections are effective, we can look at the velocity of the dollar. This consists in knowing the frequency for which a dollar unit is used to buy goods and services.

You can see that since 2008, the money injected has been used less and less to buy goods and services. On the other hand, this money injected in 2020 to revive the economy was largely invested in the financial markets and the real estate market. This has generated very high valuations in 2021, also creating more extreme inequalities, with the rich getting richer and the poor getting poorer.

dollar, currency, velocity
Source: Tradingview

Conclusion

From what we have just analyzed through this article, we can see that the financial markets are addicted to liquidity. If we follow the same dynamic in the future, as the demographic factor remains problematic in developed countries and we will need the debt to relaunch growth, this will require printing even more to maintain a minimum of growth. The more one prints, the more it becomes less efficient since the debt is greater and, consequently, the potential for growth is more weakened.

In cases like Europe or England, the problem can be even bigger. Indeed, the demographic growth of people of working age is negative, so they must continue to print so as not to jeopardize the bond market, but this has a devaluation impact on the local currency, having the effect of increase the risk of hyperinflation.

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