The US monetary base rose again in the week to Wednesday, consistent with the forecast in Tuesday's post – see first chart. As previously discussed, markets have recently been sensitive to fluctuations in the base so this pick-up may support a near-term rally in equities, possibly accompanied by a weaker or stable dollar.
The reversal of the year-end contraction in the US monetary base may also have contributed to a recent resumption of capital inflows to Hong Kong. Under the currency board arrangement such inflows automatically expand the territory's own monetary base – first chart.
A post in October suggested that the Dow industrial index might follow a path similar to the recoveries after the 1906-07, 1919-21 and 1973-74 bear markets. The second chart provides an update: the Dow recently moved below the range spanned by the three rebounds, hinting at a buying opportunity.
One caveat to a positive view is that annual growth in G7 real money supply M1 is likely to cross below that of industrial output expansion this spring – historically, equities have underperformed cash on average under such circumstances. This analysis, however, allows for near-term market gains before the macro liquidity backdrop turns less favourable.
Markets are also concerned that China's policy tightening – banks' reserve requirement ratios were raised by a further 50 basis points today – will lead to a hard landing for its economy. This hinges on whether a large positive "output gap" has already developed – if so, much higher inflation is inevitable and the authorities will be forced to slam rather than tap on the brakes.
Output gap estimates are even flakier for China than elsewhere but two pieces of evidence suggest that the economy is not yet "overheating": industrial output is slightly below its trend over the last 10 years – third chart – while companies were not reporting skilled labour shortages late last year – fourth chart. A managed slowdown may still be possible.
