Equities have lost traction recently, probably reflecting a less favourable monetary backdrop and consistent with behaviour at the equivalent stage of prior recoveries after large bear markets – see previous post. Credit markets also suggest a decline in risk appetite, with Euroland, corporate and emerging market yield spreads widening – see first chart.

Risk assets will continue to receive support from the Federal Reserve's liquidity injections. As of last Wednesday, the Fed's securities portfolio had expanded $400 billion from its level in early November when the $600 billion "QE2" programme was announced. Assuming no sterilisation, therefore, bank reserves at the Fed are on course to rise by a further $200 billion to $1.73 trillion by mid-year, equivalent to 11.5% of GDP versus a previous record (in 1940) of 6.9% – see second chart and earlier post.

Market strength in late March and early April, however, also reflected a surge in Japanese bank reserves following the 11 March tragedy, due to foreign exchange intervention to hold down the yen and an increase in Bank of Japan lending to stabilise the financial system – second chart. Reserves have fallen by $70 billion from the recent peak and may continue to decline if the central bank allows the lending rise to reverse as economic and financial conditions normalise. A return to the 11 March level would imply a further $200 billion drop.

The Bank of Japan, in other words, could neutralise the impact of the Fed's remaining liquidity injection unless it acts to sustain bank reserves at their recent higher level. The central bank, however, has announced only a modest expansion of asset purchases since the tragedy and is reluctant to target reserves, viewing such an approach as a throwback to the failed QE policy of 2001-06. Renewed yen strength may be necessary to force a more expansive stance.