Friday, September 30, 2011

Money supply update

I have commented several times on the unprecedented rise in M2 growth that started in late June. (See posts here, here, and here) I have been arguing that the increase in M2 was being driven by a capital flight from Europe; concerned that Eurozone banks were at risk of failure should there be a significant sovereign default, depositors were frantically shifting their funds into U.S. banks. This still looks to be the case, but the latest developments reflect a significant—and positive—change for the better.

As the first chart shows, M2 is no longer growing rapidly, as of the last few weeks. The bulge amount to almost $400 billion of "extra" M2, above and beyond the 5-6% growth pace of M2 that has prevailed since 1995. My first clue as to what was driving the increase of M2 was the huge rise in 2-yr Eurozone swap spreads, and swap spreads again appear to be explaining the behavior of M2. As the next chart shows, swap spreads have stopped rising, and M2 growth has leveled off. 

This next chart compares the level of 2-yr Eurozone swap spreads (orange line) with the level of M2 (white line). Both started rising about the same time, and both seem to have peaked at about the same time. 2-yr Eurozone swap spreads are an excellent proxy for the systemic risk and the fears of bank failures that have engulfed the Eurozone financial system. If swap spreads are no longer rising, then it would make sense for the capital flight out of Europe to be slowing down.

I can't prove that Eurozone swap spreads and capital flight out of Europe are what have boosted M2, but the correlation shown in the above chart is too much of a coincidence to ignore. The message here is that we may have seen the worst of the Eurozone sovereign debt and banking crisis. If so, that should prove to be a tremendous relief for equity markets everywhere.


Anonymous said...

The last time M2 growth peaked was the Dec 2008/Jan 2009 time frame. By that time the bottom of the markets was already in sight just a few months ahead.

seekingtraceevidence said...

Great insight! Thx

John said...

Considering the dismal Q3 performance on Wall Street, haven't we seen flight from stocks to cash? Wouldn't that raise the M2?

It's not all about Europe. It's also about small investors coming around to the realization that Wall Street owns a rigged game and that, up or down, the "house" always wins.

Squire said...

Yea. Get ready for a rally.