The liquidity "jaws" are closing. Annual growth in Group of Seven (G7) real narrow money, M1, was only marginally higher than industrial output expansion in January – see first chart. The series are likely to have crossed in February, with the annual output gain boosted by a large monthly decline in February 2009 falling out of the calculation.

Since 1970, global equities on average have underperfomed cash by 5% per annum when annual real M1 growth has fallen short of output expansion while outperforming by 11% pa at other times – see previous post. These averages, of course, conceal significant variation but the ex ante return / risk profile of holding equities has deteriorated.

Slower real money growth than output expansion implies that the economy is draining liquidity from markets. Historically, cross-overs have also signalled higher short-term interest rates. On average, G7 short rates have risen by 0.7 percentage points per annum during real money / output growth shortfalls while falling by 0.9 points pa at other times – second chart.

G7 plus E7 industrial output continues to rise solidly and is now only 4% below its pre-recession peak – see prior post – while the recovery is broadening to labour markets. Central bank policies adopted during the financial emergency – suppressing official interest rates below inflation and flooding banking systems with reserves – are increasingly misaligned with economic developments.

The Federal Reserve last night repeated its commitment to low interest rates for an "extended" period but this does not preclude an early withdrawal of liquidity. A rise in Chinese official rates is overdue while the UK "MPC-ometer" is close to signalling a need for policy restriction. Earlier-than-expected monetary tightening could be the trigger for a set-back in equity markets.