M2 Money Supply: The Liquidity Tide Has Turned
After the largest contraction since the 1930s, money supply growth is normalizing. Counter-intuitively, low M2 growth has historically preceded the best equity returns.
The Trade: Position for the Post-Contraction Rally
Current Setup
- M2 YoY Growth: +4.3% (21st percentile)
- Fed Balance Sheet: $6.6T (down 26% from peak)
- M2 Velocity: 1.41 (8th percentile - money still idle)
- Regime: Normalized after historic contraction
Positioning
- Overweight: QQQ, SMH, ARKK (if M2 accelerates)
- Also consider: GLD, SLV (low M2 = gold outperforms)
- Watch: XLF, KRE (if M2 decelerates further)
Counter-intuitive finding: Low/contracting M2 produces the BEST forward returns. When M2 was contracting, SPY's 6-month forward return averaged +12.4%. Current normalized M2 suggests decent (+4-8%) forward returns.
The Big Picture
From February 2020 to February 2022, M2 money supply exploded by 41%—the largest two-year increase in modern history. Then came the reversal: M2 contracted 4.7% peak-to-trough, the first sustained decline since the Great Depression.
Now the money supply is growing again, but at a historically modest 4.3% rate. What does this mean for markets? The answer is counter-intuitive: low M2 growth has historically preceded the best equity returns.
"Don't fight the Fed" is half right. The Fed's balance sheet matters, but what matters more is whether liquidity is accelerating or decelerating—and what that implies about future policy.
I. The Investment Thesis
Why low M2 growth is bullish, not bearish.
The conventional wisdom says "liquidity drives markets"—more money, higher stocks. But the data tells a different story. When we analyze 65 years of M2 growth versus subsequent equity returns, a clear pattern emerges:
| M2 Growth Regime | N (Months) | SPY 6M Forward | QQQ 6M Forward | GLD 6M Forward |
|---|---|---|---|---|
| Contracting (<0%) | 15 | +12.4% | +17.2% | +8.5% |
| Low (0-4%) | 79 | +7.6% | +9.3% | +13.4% |
| Normal (4-8%) ← Current | 236 | +4.1% | +4.8% | +4.3% |
| High (8-12%) | 44 | +5.9% | +4.6% | +3.2% |
| Very High (>12%) | 21 | +9.5% | +8.5% | +0.8% |
The Counter-Intuitive Finding
When M2 growth is lowest (contracting or 0-4%), forward equity returns are highest. This makes sense: low money growth often coincides with the end of tightening cycles, setting up for Fed easing. The market is forward-looking—it prices in the pivot before it happens.
II. Understanding M2
M2 is the broadest commonly-tracked measure of money supply. It includes:
- Currency in circulation (physical cash)
- Demand deposits (checking accounts)
- Savings deposits (money market funds, savings accounts)
- Small time deposits (CDs under $100K)
When the Fed buys assets (QE), it creates bank reserves, which can multiply into broader money supply through lending. When the Fed sells assets (QT), the process reverses.
The chart shows M2's remarkable journey: steady growth for decades, then the COVID explosion (+41% in two years), followed by the first sustained contraction since the 1930s. We're now in a normalization phase.
III. The Fed Balance Sheet Connection
QT isn't the headwind you might think.
The Fed's balance sheet peaked at $8.9 trillion in April 2022. Since then, QT has reduced it by 26% to $6.6 trillion. Conventional wisdom says this should be bad for stocks. The data disagrees:
| Fed Balance Sheet Stance | N | SPY | QQQ | SMH | TLT |
|---|---|---|---|---|---|
| QT (Contracting >$500B/yr) | 29 | +1.61% | +2.11% | +3.31% | -0.48% |
| Mild QT | 60 | +1.14% | +1.56% | +2.65% | +0.60% |
| QE (Expanding >$500B/yr) | 66 | +0.98% | +1.63% | +1.86% | +0.28% |
| Mild Expansion | 111 | +0.65% | +0.70% | +0.12% | +0.50% |
Why QT Hasn't Hurt Stocks
The Fed only does QT when the economy is strong enough to handle it. QT periods have coincided with solid earnings growth and economic expansion. The balance sheet reduction is a symptom of strength, not a cause of weakness. Semiconductors (SMH) have averaged +3.31% monthly during QT—the strongest performance of any regime.
IV. M2 Velocity: The Sleeping Giant
M2 velocity measures how many times each dollar of money supply is used for GDP transactions. Current velocity of 1.41 is at the 8th percentile historically—meaning money is sitting idle at near-record rates.
This is the untold story of the post-COVID economy: despite massive money creation, velocity collapsed as people hoarded cash. If velocity merely returns to its pre-COVID average of 1.45, that's equivalent to a 3% boost to nominal GDP without any new money creation.
V. Sector Positioning by M2 Regime
Different sectors lead depending on whether liquidity is accelerating or decelerating.
When M2 Growth is Accelerating
Tech and growth stocks lead when money supply growth is picking up:
| Asset | Monthly Return | Rationale |
|---|---|---|
| SMH (Semiconductors) | +3.08% | Duration assets benefit from liquidity expansion |
| QQQ (Nasdaq 100) | +2.08% | Growth multiples expand |
| GLD (Gold) | +1.81% | Inflation hedge, liquidity beneficiary |
| IWM (Small Caps) | +1.59% | Risk appetite increases |
| SPY (S&P 500) | +1.45% | Broad market lifts |
When M2 Growth is Decelerating
Financials and value tend to outperform when liquidity is tightening:
| Asset | Monthly Return | Rationale |
|---|---|---|
| XLF (Financials) | +1.08% | Higher rates help NIM, quality focus |
| XLE (Energy) | +1.26% | Real asset, inflation hedge |
| XLY (Discretionary) | +1.15% | Consumer still spending |
| GLD (Gold) | +0.91% | Uncertainty hedge |
| TLT (Long Treasuries) | -0.23% | Duration risk, higher-for-longer rates |
VI. Current Assessment and Outlook
Where We Are Now
- M2 Growth: 4.3% YoY (21st percentile) — In "Normal" regime, near "Low" boundary
- M2 Acceleration: Stable (-0.16% 3-month change in YoY rate)
- Fed Balance Sheet: $6.6T, down 26% from peak, QT slowing
- M2 Velocity: 1.41 (8th percentile) — Money still sitting idle
The current setup is constructive but not euphoric. M2 growth has normalized from the COVID extremes. Forward returns from "Normal" M2 regimes average +4.1% over 6 months—positive but not spectacular.
The upside scenario: If M2 growth slips into the "Low" (0-4%) range, historical data suggests stronger forward returns. If velocity picks up from its depressed level, that's an additional tailwind.
The risk scenario: If M2 re-accelerates sharply (unlikely given current Fed stance), watch for inflation concerns and bond selloffs. Very high M2 growth eventually leads to inflation problems.
VII. Implementation: Specific Tickers
Diversified positioning across the liquidity spectrum.
If M2 Accelerates (Risk-On)
Semiconductor leaders (liquidity beta):
If M2 Decelerates (Quality/Value)
Money center banks (NIM beneficiaries):
Energy majors (real asset exposure):
Low M2 Environment (Gold Shines)
Gold miners (leveraged gold exposure):
International Exposure (EM Liquidity Play)
VIII. Conclusion
The Verdict: Constructive, With a Counter-Intuitive Twist
M2 money supply has normalized after the COVID extremes. The current 4.3% growth rate is in the "Normal" regime, which historically produces moderate (+4-8%) forward returns.
The counter-intuitive insight: don't fear low M2 growth. Contracting and low M2 periods have preceded the strongest equity returns, likely because they set up for Fed easing. Current conditions are supportive.
- If M2 accelerates: Overweight semis, growth, and small caps (SMH, QQQ, IWM, ARKK)
- If M2 decelerates: Overweight financials, energy, and value (XLF, XLE, VTV)
- Either way: Gold has performed well in both scenarios (GLD, GDX)
Key watch: M2 velocity at 1.41 (8th percentile). If money starts moving again, that's an additional boost to nominal GDP and risk assets without any new money printing required.
Explore the Data
FRED Explorer
Explore M2, Fed balance sheet, velocity, and 800K+ economic time series.
Open FRED Explorer