Monetary condition analysis is the first part of an overall market analysis consisting of (1) monetary conditions analysis for long term forces, (2) primary breadth trend analysis for intermediate term forces, and (3) market breadth pattern analysis for short term forces I believe affecting the broad stock market.
When monetary policy is easy, slowly its effect will be felt in asset prices for extended period of time. Major bull runs in stock prices (including housing or any other speculative assets in vogue at that time) are often preceded with extremely easy monetary policy. On the other hand, when monetary policy is tightened, slowly stock prices often exhibit chaotic behaviour before eventual down trend in line with slow down in business cycle.
The are mainly two variables in which the Fed can influence money supply: (i) target of Fed funds rate and (ii) the size of the Fed’s balance sheet. It is only since the great financial crisis of 2008 that the Fed is actively using the second variable. In principle, easy monetary policy is characterized by lower target of Fed funds rate and expansion of the Fed’s balance sheet.
The first chart below show target Fed funds rate together with long-term treasury yields. It has been discovered in several academic studies that the slope of the yield curve (e.g. Y05-Target) is a useful predictor of the stock market and the broad economy. Indeed, the slope of the yield curve is often included as part of significant leading indicators in many systems to predict the economy.
However, what I focus on is not the slope itself, but accumulation of the slope. Basically, the longer the slope is positive, the more easy is the monetary stance, the larger liquidity will slosh around the system, and the more favorable it is for asset prices (including stock market, housing, or other risky assets which does not lose value in the face of inflation) but adverse for the dollar.
The second chart shows cumulative of (yield slope – typical slope) since 1985. I call this indicator “Interest Rate Pump Factor”. Monetary liquidity is being pumped to the system whenever slope is bigger than its typical value. You can view typical slope as normal liquidity premium, i.e. investor prefer short-term debt than long-term debt of the same quality. I did not go much earlier than 1985 because the monetary arrangements back then was so much different from now. Typical slope is chosen so that cumulative sum over the whole period is zero. No doubt there is an element of hindsight with the setting of typical slope.
You can see that when the pump factor is high, the stock market usually will continue its bull run at least for the next 6 months. Corrections are always bid up. When the factor is low or negative, usually the market is not too far from bear market. The crash in 1987 is not a bear market to me. It is more like an accidental market correction which then strongly bid up due to favorable monetary conditions. However, the market decline in early 1990 proves short-lived. The biggest bull run in mid 1990s coincide with very favorable monetary conditions as indicated by the factor. Bear markets in both early 2000s and 2008 were preceded with severe monetary liquidity.
Now, the Fed is threading uncharted territory. Not happy with lowering target Fed funds rate close to zero, it is also expanding its balance sheet significantly. Although not included in “Interest Rate Pump Factor”, the action effectively increase monetary liquidity significantly. The big question is how expansion of balance sheet can reliably be used to predict expansion or correction of asset prices. This question I cannot satisfactorily answer because there is not historical precedent.
What is clear though, monetary liquidity is expanding rapidly. Perhaps because of this, we saw every corrections so far are always being bid up. This is not likely to stop any time soon.