Liquidity is buoying stocks

Stock markets continue to oscillate on Hormuz strait news but there seems to be plenty of money wanting to buy. Confidence in rising profits and low interest rates (when/if the war ends), is a key part of the story but so is ample liquidity. Where is that coming from? Isn’t quantitative tightening (QT) supposed to be reducing liquidity? The answer is yes, but it is offset by other factors.

By liquidity we mean money and other safe short term paper assets such as money market funds and Treasury bills. The simplest measure is money M2 though that does not capture the full range of liquid instruments. The boundaries are amorphous to some extent in any case.

QT drains liquidity because the central bank is either selling its holdings of bonds (Bank of England) or not reinvesting them (the Fed). That means more government paper to be held by investors, who pay for it from their money balances. 

But government deficits add to liquidity too. The deficit is spent which results in cash in peoples’ bank accounts. It is also financed which drains the same amount. But only part of the financing is long-term bonds. Some is short-term Treasury bills and although that drains pure cash just the same, it still leaves investors with plenty of short-term liquidity. If they feel confident about stocks they may sell some T-bills to increase their stock-holdings.

Of course, money doesn’t ‘flow into stocks’ on a net basis because for every buyer there is a seller. But if there are more buyers than sellers, stock prices go up. Interestingly, the share of short-term funding has been rising under Treasury Secretary Bessent. The government is expected to issue $555bn net new short-term paper in 2026, up from $344bn in 2025, while long-term issuance will be $1.5 tr, down from $1.9 tn.

For a while in 2023-4, QT was offset by the run-down of the Fed’s Reverse Repo Facility (RRP). In a reverse repo the Fed takes in cash in a temporary exchange for bonds, which reduces liquidity. That run-down added almost $2.5 tr to liquidity in 2023-4. But the RRP is now close to zero so is no longer playing a role. However, the Fed adjusted policy in December and is now starting to grow its overall balance sheet again by buying Treasury bills (increasing liquidity). It is doing this to help ensure plentiful liquidity in money markets and avoid any spikes in interest rates.

Another boost to liquidity is coming from increasing bank lending. When interest rates were hiked in 2022, lending slowed right down, but it is up again now (see chart). The year-on-year increase is about 7% but it has been accelerating, hitting 9.1% annualised over the last 6 months. The main components are increased lending to business, and to ‘financial non-depositary institutions’, which includes direct mortgage lenders, insurance companies, private equity, private debt, and hedge funds among others.

Meanwhile margin debt (where investors borrow to buy securities) fell slightly when the war started but is up strongly over the last year (see chart). As a percentage of the value of stocks it is not exceptional, but a rise like this is part of the liquidity that drives prices higher.

The final source of liquidity is foreign buying of US stocks and bonds. It’s true that non-US central banks are now also following QT, lowering liquidity. But interest rates have come down around the world and government deficits have risen in Europe and China.

Looking forward

None of these trends look likely to change soon. The US budget deficit, already large, may even increase if defence spending rises as the President has proposed. Meanwhile repayment of some of the tariffs collected last year is set to begin. Perhaps the one fly in the ointment is the expected rise in Japanese interest rates which may discourage ‘carry trades’ over time.

Liquidity is only part of the story of course. Investors need to feel optimistic to exchange liquid assets for risky assets. But if oil prices would only settle down, the prospect of strongly rising US profits, economic recovery in Europe, and the AI revolution, could soon stimulate buying. Ample and rising liquidity is a strong support.

The downsides

Two risks come to mind. First, bubbles. Will stocks rise to valuations that are simply ridiculous?  Leading to a crash. We and others have worried about that for a while in relation to the US market. But US earnings have been rising in double digits, helping to limit the excess. If forward earnings expectations are to be believed the PE of the Magnificent Seven has fallen from the low 30s to the mid 20s, though that is still high. Everything depends really on the outcome of AI investments for profits - still unknown. It could be different this time. Or not.

The second and related concern is that, historically, high valuations mean lower returns over the medium and long run. In other words, high liquidity brings forward stock market gains but doesn't increase them, on a long term view.