Central bank liquidity and stocks
Is central bank liquidity a key determinant of stock-market returns? In February, we wrote about how Japan’s unorthodox monetary policy was probably boosting global equity markets, even as the Federal Reserve was tightening.
Indeed, there is a 96 percent historic correlation between the combined balance sheets of the world’s major central banks and the performance of the S&P 500.1
In the chart above, we track the theoretical value of what the S&P 500 “should” have been, given that correlation, against the US stock benchmark’s actual performance.
The second panel expresses this relationship in a different way, measuring the S&P’s variance from the model. The one-standard-deviation range is highlighted in gray.
As central banks drain liquidity, the S&P 500 has crept higher and is more than 1 standard deviation away from the trend. Are we headed for a correction, or will markets defy shrinking balance sheets as they did during the tech-driven surge of 2018-19?
1To be precise, this assertion refers to the R2 statistical measure used in regression model analysis.