The Business Times, Wednesday 25 Jun, 2008

MONEY MATTERS

Follow the money supply

Follow the money supplAcceleration and deceleration in money supply tend to lead stock market performance by up to four to eight months.

By JOSEPH CHONG

THERE is an old adage in investing: to make money, follow the money. Yes, it is always an advantage to know the potential direction of funds flow when investing. Many investors follow indicators such as fund manager cash levels or money market fund sizes to gauge this. One of the most important 'follow the money' indicators that we watch as professional investors is the money supply data of the major economies - the ultimate source of funds flow. Indeed, there is very good correlation between money supply growth rates and the movement of stock and currency markets.

When the media refers to the US Federal Reserve 'changing interest rates', the federal funds rate (currently 2 per cent) is almost always what is meant. The federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Fed to other depository institutions, usually overnight. This rate is a target set by the governors of the Fed, which they enforce primarily by open market operations.
 

In open market operations, the Fed most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money. These trades are made with a group of banks or bond dealers who are called primary dealers. Alternatively, it may permanently create money by the outright purchase of securities. Very rarely will it permanently destroy money by the outright sale of securities. Money is created with a repo simply by electronically increasing the reserve account at a bank. Money is destroyed with a reverse repo simply by decreasing the reserve account of a bank. The European Central Bank and the Bank of Japan function in a similar way to maintain overnight interest rates at a certain target level. Thus, money supply expands or contracts depending on the interest rate targets of the central banks. Generally, money supply growth rates will increase as more money needs to be 'created' in an economy in order to reduce interest rates. Money supply growth rates decrease as money has to be 'destroyed' to raise interest rates.

How does this affect stock markets? Acceleration and deceleration in money supply tend to lead stock market performance by up to four to eight months. Chart 1 shows this correlation in 2002 to 2003 over a period of 78 weeks between M2 in the US and the S&P Global 100, which is a global equities index of 100 of the largest companies. M2 is the broadest measure of the money supply growth rate monitored by the Fed. M2 bottomed in June 2002 and global stock markets formed a double bottom four to eight months later. US and global GDP subsequently re-accelerated a further six months later. Indeed, the Fed had to lower interest rates to below 2 per cent then to turn M2 around. The global economy then faced the severe headwinds of the Telecom-Tech bust, 9/11 and Sars. These notwithstanding, the magic of money supply prevailed.

TChart 2 shows the current correlation. M2 bottomed in January 2008, with equities following two months later. Changes in money supply growth rates also affect currency values. Over a three-month period from Jan 23, 2008, the US dollar fell in value from 1.46 to 1.6 to the Euro. This was the period when M2 in the US expanded aggressively from 5.2 per cent to 11.2 per cent while broad money supply growth in the Euro zone was steady. When a central bank creates money more aggressively than others, it is logical for its currency to decline in relative value - this is what has happened. Money, like any other good or service, will fall in value when there is too much supply.

The concept of money supply is so effective that it also explains the drag that higher energy and food costs are imposing on equity markets. An even tighter correlation between money supply and stock market performance is the concept of excess money supply. Excess money supply is M2 or M3 less the prevailing nominal GDP growth rate. Nominal GDP is GDP not adjusted for inflation. The excess money supply indicator is more difficult to work with because of the uncertainty associated with estimating current nominal GDP. GDP figures are normally only finalised months after the fact. Nevertheless, excess money supply is currently being squeezed as higher inflation is driving nominal GDP growth rates higher. Less excess money supply means less money available for the investment markets. Hence, stabilisation in oil prices should lead to a rally in stock markets.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions