Since late February, weak economic data and President Donald Trump's trade war have hit the stock market hard, with the broader benchmark, the S&P 500, even briefly entering correction territory. Investors have also turned more bearish on concerns of a recession, or even stagflation, arriving this year.
But not all data has been bad. In fact, over the last year, U.S. money supply has been rapidly rising, which has historically had a positive correlation with stocks.
Does that mean the stock market is about to make an epic recovery?
What is M2 money supply?
Money supply can sound like a very generic reference and you might be wondering how one can gauge such a broad data point.
But the Federal Reserve in its broad data-gathering activities actually tracks something called the M2 money supply. To arrive at M2, the Fed measures liquid cash consumers have on hand, money in checking and savings accounts, and certificates of deposits. However, M2 does not include retirement savings and time deposits above $100,000.
The Fed can manipulate the money supply in order to help achieve its dual mandate of price stability and maximum employment. The Fed has tools at its disposal, such as interest rate changes, and quantitative easing and tightening, to influence the money supply. Some believe that money supply can also help people gauge inflation because if there is more money circulating through the economy then there is likely -- although not always -- going to be more spending.
M2 money supply has been climbing fast in the 21st century as the Fed has pumped money into the economy after several significant economic downturns including the Great Recession and the COVID-19 pandemic. The U.S. Treasury Department has also increased debt to make up for revenue shortfalls, which has had an impact on M2 as well.
However, M2 really surged following the pandemic. The Fed began the process of quantitative tightening (QT) in which it sells bonds on its balance sheet, effectively sucking money out of the economy. The Fed is still conducting QT, but since the start of 2024, the M2 money supply has begun to rise again.
US M2 Money Supply data by YCharts.
A bulk of this new increase likely has to do with the Fed's interest rate cuts, which began last September. The Fed cut its federal funds rate by a total of 1 percentage point at its September, November, and December meetings before going on pause. Lowering interest rates tends to increase the money supply because it makes borrowing cheaper.
Is an epic recovery on the way?
More money in the economy can inflate assets like stocks. Some also think an increasing money supply favors smaller companies because they'll have better access to capital and therefore more opportunity to expand. While not a perfect correlation, there certainly appears to be some link between the growing money supply and performance of the S&P 500 since the turn of the 21st century.
US M2 Money Supply data by YCharts.
But not all agree with this. Fed Chairman Jerome Powell has previously indicated he does not see a high correlation between M2 and economic growth. The other concern about a growing money supply is its impact on inflation, which has been a headache for the U.S. economy since 2022.
While the Fed has made progress on its goal to lower inflation to its preferred 2% target, the number is still closer to 3%. Rebounding inflation would also likely be very bad for the economy and stock market because it could start to raise concerns about stagflation -- where the labor market deteriorates and prices stay elevated, resulting in anemic economic growth.
Therefore, I think it's too early to determine if a growing money supply will trigger an epic stock market recovery. The U.S. is still not out of the woods yet on inflation and Trump is still waging a trade war that could lead to higher inflation over time, potentially even forcing the Fed to raise rates, however unlikely that seems right now. That doesn't mean you can't invest right now, but try to stay away from stocks trading at nosebleed valuations.
