A prior post drew attention to a sharp increase in the US and Eurozone monetary base – currency plus bank reserves – during the first half of May, suggesting that this would contribute to a short-term rally in equity markets and other risk assets. This rise, however, has been partially reversed over the last fortnight – see first chart.

Lows in the US monetary base have preceded US equity market troughs by between two and four weeks since early 2009 – see earlier post. The base bottomed in the week to 5th May while the lowest close for share prices during the recent decline was on 26th May. The base was still 2.7% above its early May trough in the week to Wednesday.

Recent developments echo June / July 2009. The US monetary base fell back after an initial recovery but equities continued to rally strongly – first chart. This may have reflected offsetting stimulus from a large increase in the Eurozone base in late June, resulting from a 12-month ECB lending operation.

The Eurozone monetary base has again risen by more than its US counterpart in recent weeks, though by less than in June 2009. The ECB has curbed the increase by issuing one-week deposits to sterilise the impact of bond purchases under its securities markets programme. Banks, however, are likely to regard these deposits as a close substitute for reserves. An expanded monetary base definition including term deposits has risen by 9.6% since late April.

Measures of equity market sentiment, meanwhile, have recovered from oversold extremes as prices have rallied but are not yet signalling exuberance. The 10-day moving average of the CBOE put / call ratio, for example, remains above levels reached before recent short-term market peaks – second chart.

The current rally, therefore, may have further to run but is likely to face increasing headwinds unless monetary base expansion resumes. The wider macroliquidity backdrop, moreover, remains cautionary, with global real narrow money, M1, growing more slowly than industrial output, suggesting insufficient monetary fuel to power sustained market strength.