Previous posts have argued that the escalation of the Eurozone sovereign debt crisis and associated weakness in equity markets reflected deteriorating global liquidity conditions. One aspect of this deterioration was a 9.4% contraction in the US monetary base (currency and bank reserves) between late February and early May – see chart.

A key issue for markets, therefore, is whether the crisis results in a significant reinjection of liquidity by central banks. A post last week suggested that the US and Eurozone monetary bases would expand but by less than needed to recreate bull market conditions. The Fed's response seemed likely to be constrained by strong domestic economic news while the ECB had signalled its intention of sterilising the impact of its bond purchases.

The latest US figures confirm that the Fed has injected liquidity in response to the crisis, resulting in a 2.3% rise in the monetary base in the week to Wednesday – the first increase for seven weeks. This was achieved by the Treasury running down its cash balance at the Fed. Currency swap lending to European central banks should result in a further rise in the base this week. The Fed, however, is unlikely to wish fully to reverse its earlier liquidity withdrawal.

Eurozone monetary base figures for last week – released tomorrow – will be boosted by the six-month repo operation conducted on Wednesday, at which the ECB lent €35.7 billion (equivalent to 2.8% of the monetary base), and the initial impact of its bond purchases. The ECB's claim that it will sterilise its bond-buying is suspect since it has limited control of the monetary base as long as repo lending is on a full-allotment basis.

Central bank liquidity injections could be laying the foundation for a bottom in equities and other risk assets but caution remains warranted until the US / Eurozone monetary base show more significant and sustained expansion. Note, also, that prior US market troughs over the last 18 months have occurred several weeks after the low in the monetary base – see chart.