Global Easing and Weaker Dollar Fuel Rising Excess Liquidity, Boost Stocks
A shift in global monetary policy, now extending to the U.S., and a weaker dollar are fueling an increase in excess liquidity, which continues to support stock market growth. With recession risks relatively low in the near term, the current environment remains conducive to the continuation of the primary upward trend in equities.
The Federal Reserve's recent decision to ease monetary policy marks the first rate cut since March 2020, ending one of the longest periods between rate cuts in the past 70 years. This initial cut of 50 basis points (bps) was larger than expected. Notably, financial conditions are unusually loose as the Fed begins this easing cycle, and excess liquidity remains robust, poised to increase further. Rather than diminishing, longer-term inflation risks may actually be rising.
Excess liquidity, defined as the difference between real money growth and economic growth, is a reliable medium-term indicator of performance in risk assets such as stocks. Historically, G10 excess liquidity leads the performance of U.S. equities by about six months. Since the first quarter of 2023, this indicator has been on a steady upward trajectory, reinforcing the outlook that the stock market's path of least resistance continues to be upward.
Despite the tightening monetary conditions over the past several years, excess liquidity is experiencing one of its most significant accelerations in 50 years. This momentum shows no signs of slowing down due to two main factors: easing global monetary policies and a weakening U.S. dollar. As central banks around the world begin to cut rates and the dollar continues to lose strength, excess liquidity is expected to keep expanding.
The mechanics of excess liquidity are straightforward: banks and central banks create money, and the portion that isn't absorbed by inflation or economic growth becomes "excess," flowing into risk-asset markets. This excess collapsed when central banks initially raised rates to curb inflation but has been growing again as the economy demands less liquidity. Money growth, while still lower than in past years, is increasing relative to its long-term trend, and the negative impacts of inflation on excess liquidity are diminishing as price growth slows.
Even though G10 real money growth remains negative on an annual basis, it is now rising sharply. It's this second derivative—how the rate of growth is changing—that is most important for assessing excess liquidity and risk assets. Central banks outside of the U.S. had already begun easing rates before the Fed, but with the Fed now joining in, there is potential for further reductions and stronger real money growth globally.
The dollar plays a critical role in boosting excess liquidity as well. G10 excess liquidity is calculated in dollar terms, meaning that when the dollar weakens, it enhances liquidity. Since the dollar peaked in September 2022, excess liquidity has been on the rise, with local-currency liquidity increasing significantly. As non-U.S. central banks like the European Central Bank (ECB), Bank of England (BOE), and Bank of Canada (BOC) began easing and expanding their money supply, excess liquidity continued to grow.
Currently, the dollar is near the bottom of its trading range, and if it breaks lower, it could fall by another 10% to the levels seen in 2021. A weaker dollar would further boost excess liquidity, especially since the real yield curve—which leads the dollar by several months—has started to turn down, signaling more potential dollar weakness ahead.
Real rates in the U.S. are rising in the short term as inflation softens, while longer-term real yields are falling, reflecting expectations of more rate cuts by the Fed. This has reduced demand for U.S. bonds from foreign investors, contributing to dollar weakness. If this trend continues, the outlook for excess liquidity will remain positive, supporting risk assets like stocks.
However, there are concerns that the Fed's easing cycle might contribute to inflationary pressures in the longer term. While the stock market stands to benefit from higher liquidity, the risk of inflation could complicate the economic outlook. Real returns, after all, are the key focus for investors. Thus, while excess liquidity is likely to continue fueling risk assets, the potential for inflation to rise as a result of monetary easing is a concern to watch closely.