Can the stock market surge again as global central banks shift from draining to releasing liquidity?

According to Zhitong Finance APP, a surprising phenomenon in 2024 is that despite global central banks draining liquidity from the financial system, the stock market has risen significantly against the trend. In this context, the market begins to explore a question: If the liquidity drain has not posed a significant obstacle to this year's market, will an improvement in liquidity next year become a tailwind for the market? Looking ahead, global economic growth is expected to slow, partly due to increased uncertainty in U.S. trade policy, while major economies such as China, Europe, and Canada are expected to implement more accommodative monetary policies. The Federal Reserve is lowering interest rates and may gradually end its quantitative tightening (QT) program, which has reduced the Fed's balance sheet by $2 trillion since mid-2022. In short, the trend of liquidity exhaustion may reverse.

However, the difficulty in assessing the impact of liquidity on asset prices lies in the challenge of tracking liquidity levels in financial markets and the global banking system. Liquidity is often measured by the size of central bank balance sheets, although this measurement is somewhat rough; the logic is that a larger balance sheet (especially with higher bank reserve levels) typically indicates stronger stock market performance.

For example, a model by Citigroup analysts shows that for every $100 billion change in bank reserves held by the Federal Reserve, it corresponds to about a 1% change in the S&P 500 index. Based on this calculation, this year, due to a reduction of about $200 billion in reserves, Wall Street should theoretically have faced a 2% hit. However, from a global perspective, the 12-month change in bank reserves is about $600 billion, which seems to suggest that global stock markets should have experienced a larger decline. The reality is that the S&P 500 index has risen nearly 30% this year, and the MSCI World Index has also increased by 20%.

Additionally, the total size of the balance sheets of the "G4" central banks (the Federal Reserve, European Central Bank, Bank of England, and Bank of Japan) decreased by $2.2 trillion in both 2022 and 2023, yet global stock markets fell by 20% that year and then rose by 20% the following year. These facts indicate that liquidity is just one of many factors affecting the market; economic growth, geopolitical issues, technological developments, earnings, regulatory policies, investor sentiment, and many other factors can also have daily impacts on the market.

However, this does not mean that investors can completely ignore changes in liquidity. When assessing the implied market liquidity conditions from central bank balance sheets, paying attention to bank reserves remains very useful. If reserves are too low, it may trigger soaring money market interest rates, increased concerns about credit tightening, and behaviors such as investors selling off risk assets.

Currently, U.S. bank reserves are about $3.2 trillion, considered "ample," but the Federal Reserve's goal is to adjust these reserves to "adequate" levels, which is precisely what its ongoing balance sheet reduction plan aims to achieve.

Policymakers are reassured that so far, interest rate cuts have not had a significant impact on financial markets, as U.S. Treasury Secretary Janet Yellen stated, this process is "like watching paint dry." However, the market may experience volatility in early 2025, prompting the Federal Reserve to pause its quantitative tightening policy Especially when former President Donald Trump returns to the White House, the U.S. debt ceiling issue is once again highlighted, and cash in the Federal Reserve's overnight repurchase mechanism (RRP) may drop to zero, all of which could signal the disappearance of what some Federal Reserve officials consider "excess" liquidity. Goldman Sachs analysts expect the Federal Reserve to end its quantitative tightening policy in the second quarter, while other analysts believe it may happen even sooner.

The balance sheets of the Federal Reserve, European Central Bank, and Bank of England currently account for the lowest proportion of their respective GDPs since early 2020 (pre-pandemic). Jefferies Chief Market Strategist David Zervos predicted in February this year that when the Federal Reserve's balance sheet reaches $7 trillion, the quantitative tightening policy will stop, and the current size of the Federal Reserve's balance sheet is approaching this level.

Zervos pointed out, "This is a massive balance sheet... a huge stimulus. It raises yields, nominal GDP, profits, and valuations." Even though there is no direct mechanical link between central bank liquidity and the market, the "huge" balance sheet of the Federal Reserve signals that policymakers want to keep liquidity at stimulative levels to support the market. Therefore, the expectation of rising liquidity (or at least no further decline) may be enough to boost risk appetite and add additional upward momentum to an already hot market next year