According to Zhizhong Financial APP, a surprising phenomenon in 2024 is that although global central banks have withdrawn liquidity from the financial system, the stock market has surged against the trend. In this context, the market begins to explore a question: If the withdrawal of liquidity has not posed a significant obstacle to this year's market, will an improvement in liquidity next year serve as a tailwind for the market?

Looking ahead, global economic growth is expected to slow, partly due to increased uncertainty regarding USA trade policies, while major economies such as China, Europe, and Canada are expected to implement looser monetary policies. The Federal Reserve is lowering interest rates and may gradually end its Algo tightening (QT) plan, which has reduced the Federal Reserve's balance sheet by 2 trillion dollars since mid-2022. In short, the trend of liquidity depletion may reverse.

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

For example, a model from Citibank analysts shows that every change of $100 billion in bank reserves held by the Federal Reserve corresponds to an approximate 1% change in the S&P 500 Index. Based on this calculation, since reserves were reduced by about $200 billion this year, Wall Street should theoretically experience a 2% hit. However, from a global perspective, the 12-month change in bank reserves is approximately $600 billion, which seems to suggest a larger decline in the global stock markets. Yet, 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%.

Moreover, 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, but the global stock market fell 20% that year and then rose 20% the following year. These facts indicate that liquidity is just one of many factors influencing the market, and factors such as economic growth, geopolitics, technological developments, earnings conditions, regulatory policies, investor psychology, and many others may have a daily impact on the market.

However, this does not mean that investors can completely ignore changes in liquidity. When assessing the implied market liquidity conditions from the central bank's balance sheet, paying attention to bank reserves is still very useful. If reserves are too low, it may trigger soaring money market rates, intensify concerns over credit tightening, and lead investors to sell off risk assets.

Currently, the reserves of Bank of America are approximately $3.2 trillion, which is considered 'ample', but the Federal Reserve's goal is to adjust these reserves to an 'appropriate' level, which is precisely what its ongoing balance sheet reduction plan aims to achieve.

Policymakers are reassured that so far, interest rate cuts have not significantly impacted the financial markets, as US Treasury Secretary Janet Yellen stated, this process is 'like watching paint dry'. However, the market may experience fluctuations in early 2025, prompting the Federal Reserve to pause quantitative tightening policies.

This is especially true when President Donald Trump returns to the White House, the USA's debt ceiling issue is highlighted again, and cash in the Federal Reserve's overnight reverse repurchase agreement (RRP) could drop to zero, all of which may indicate the disappearance of the "excess" liquidity that some Federal Reserve officials believe exists. Analysts at Goldman Sachs expect the Federal Reserve to end its quantitative tightening policy by the second quarter, while other analysts suggest it could happen even earlier.

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

Zervos pointed out: "This is a massive balance sheet... a great stimulus. It has raised returns, 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 sends a signal that policymakers want to maintain liquidity at stimulating 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 extra upward momentum to an already hot market for next year.

Editor/ping