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The Recent Spike in Money Supply

If you've spent any time trading markets, you've likely heard that increases in the money supply lift the price of assets, like stocks, for example.  You can read more about that here and here.

Well since March of 2011, stocks have done this:

That's down about 17%.  Meanwhile the growth rate of the "M2" money supply has done this:

There clearly seems to be a problem with the theory that increases in the money supply helps lift stock prices.  This could actually be due to a number of different factors.  First, though, we might want to know what's in the monetary aggregate known as "M2":

Over the last several months, the growth rates of the components look like this:

The largest component of M2 is savings deposits.  These are simple, good ol' fashioned savings accounts.  These are up 20% year-over-year.  The highest growth rate was in demand deposits, which are mainly checking accounts.  While up close to 60%, demand deposits are a relatively small percentage of M2.  By far, the one thing driving the recent spike in money growth is the 20% increase in savings deposits.

Oddly, when the S&P 500 drops as much as it has since late spring, you tend to see an increase in retail money market funds.  This time, the amount in retail money market mutual funds has dropped by 6.41%.  The 27% drop in small time deposits, which are CDs worth less than $100,000, is also a little surprising.  It could be that the dollars that normally go into CDs and money market funds have gone to bonds and bond mutual funds.  Certainly, interest rates are low enough to force investors to hunt for yield from other sources not previously utilized.

According to the Board of Governors of the Federal Reserve System, savings deposits include passbook savings accounts and money market deposit accounts.  It's hard to imagine that money market mutual funds and CDs are being shunned in favor of money market deposit accounts, which invest in the very same low-yielding assets.

Some feel that the US savings deposit growth is being driven by a flight out of European deposit accounts at those fragile European banking institutions.  And that may be true, but does this explain the spike in money supply?  No.  Foreigners wishing to take money out of European banks and put it into US savings accounts are not creating money.  They are simply exchanging eruos for dollars that already existed.  It has to be that loans are being created and the proceeds deposited into savings accounts.  Regardless, whoever is creating the money through loans is not buying equities with it.  However, once created, money does have a way of finding the stock market eventually.  It should come as no surprise that as the US slips into a recession, dollars are shying away from the risk of stocks.

The breakdown in the relationship recently may simply be that it takes time for the creation of money to find its way into the real economy and equities.  And that makes sense given that the money supply is a leading indicator.  In fact, some consider it to be a long leading indicator.  And it happens quite frequently, actually, that many months go by before the money created has an impact on risk assets.  Right now, its pretty much this spike in M2 that is keeping the Conference Board's index of leading economic indicators from plummeting straight to 0.  Very few other leading indicators are showing any strength at all.