ORLANDO, Florida -One of the many curiosities of 2024 has been how global stocks have surged so strongly even as central banks have drained liquidity from the system. The question for markets is, if draining liquidity wasn't much of a headwind this year, will its likely reversal next year turn into a tailwind?
Liquidity has often been measured, albeit crudely, by the size of central bank balance sheets, with the assumption being that bigger balance sheets – and especially higher levels of bank reserves – mean stronger equity markets. Or consider that the combined size of the 'G4' central bank balance sheets fell by $2.2 trillion in both 2022 and 2023, yet world stocks fell 20% in one year, then rose 20% the next.
Policymakers will be pleased that – at least thus far – this reduction has not seriously impacted financial markets. It has been"like watching paint dry," as U.S. Treasury Secretary Janet Yellen once quipped. And why not? The balance sheets of the Fed, European Central Bank and Bank of England are all the smallest they've been as a share of their respective GDPs since early 2020, before the pandemic.
Even if there is no mechanical link between central bank liquidity and markets, a"colossal" Fed balance sheet sends a signal that policymakers want to keep liquidity at stimulative levels and have the market's back.