Understanding Financial Deepening: Global Money Supply, Global GDP & How It Affects Asset Prices
INTRODUCTION
‘Financial Deepening’. Sounds fancy, right? Maybe even somewhat intellectual – like something some stuffy Chief Economist discusses over brandy whilst he scratches his sorry excuse for a beard and shuffles uncomfortably in his seat, dog hairs all over his Tweeds.
Well, it ain’t fancy today – but it is important.
I don’t want to come at this from a textbook macroeconomic perspective, but rather from that of a speculator. As speculators, the most important thing we can know is what drives the prices of the assets in which we speculate – and for me that thing, at least since 2008, has been the phenomenon of financial deepening.
So, what is financial deepening? Well, the textbooks might assert that this is the process by which the financial sector grows within an economy, but for us it is the process by which risk assets have a persistent bid.
The clearest way to express this is that financial deepening is the phenomenon by which the growth in money supply outpaces the growth in provision of goods and services: i.e. M2 is growing faster than GDP.
The inverse of this is called the Velocity of Money, or rather the number of times the same money is used to purchase goods and services.
Now, given our focus is speculation – and primarily speculation in global markets – we will be looking at global financial deepening; that is, growth in global money supply outpacing growth in global GDP.
This does two things: firstly, it makes my job easier because I don’t need to bore you with the nuances of each and every economy; and secondly, it allows for the presentation of a more cohesive argument about how this phenomenon globally affects risk assets.
Basically, if we were looking at individual countries, we would have to contend with such things as imports and ‘capital flight’. But since we will be considering this globally – and we do indeed live in a progressively globalised economy – there are only three things we need consider:
Inflation + Speculation + Hoarding
If I’m getting a little ahead of myself, let me take a step back.
We have established that the phenomenon of global financial deepening is where global money supply is growing at a faster rate than global GDP (that is the provision of goods and services around the world).
We also need to establish that unless we normalise the numbers in a single currency (let’s say the reserve currency of the world – the Dollar), the argument is meaningless. Money supply expanding in Pesos and GDP expanding in Euros does nothing for us. We need to know how much the global money supply is expanding when converted into Dollars, and same goes for global GDP. Only then can we make any judgements and assertions.
So, I’ve been rambling for a while now – and it seems pertinent to share some visuals.
The premise of this post is that for the past two decades (if not longer) we have been living in a world in which global money supply has been expanding faster than global GDP, in relatively consistent multi-year cycles, when normalised into US Dollars.
You can see this expressed below:
In the chart above, the white line shows Global M2 / Global GDP for21 countries. You can find the indicator for yourself here. The candles show the S&P 500. And the pane below both shows the Year-on-Year % Growth in Global M2.
Global M2 here is calculated by taking money supply data from those 21 countries and converting into Dollars using exchange rates in real time, and the same goes for Global GDP. You can feel free to own proxy for this with simple formulas using open-source data, but I find the indicator linked above to be perfectly suitable for our purposes.
And what can we parse from the apparently sizeable correlations here?
Well, since 2008, returns in the S&P 500 have been broadly correlated (though not absolutely) with growth in Global M2 outpacing growth in Global GDP.
And below we can see the Nasdaq 100 is also relatively highly correlated with Global M2 / Global GDP:
So, we’ve now established that returns for the world’s largest equity indices are highly correlated with this measure of global financial deepening.
But why does this appear to be the case? Why do central banks employ policies that lead to this phenomenon? What is the relationship between financial deepening and asset prices – and how can we use this to our benefit as speculators?
Subscribe to Ostium Labs
Receive the latest updates directly to your inbox
Your subscription could not be saved. Please try again.
Your subscription has been successful.
FINANCIAL DEEPENING AND HOW IT AFFECTS ASSET PRICES
Remember how earlier in this post I mentioned our stuffy Chief Economist? Well, let’s bring him back and let’s name him Graham…
Graham is sat in his armchair furiously typing up a new essay why central bankers are all fools, and how their decisions lead to valuation distortions and wealth inequality and how the house of cards must inevitably come tumbling down.
Graham is smart, but a fool himself.
As we will come to see, in this era of financial deepening, valuation distortions are a feature, not a bug.
In a progressively globalised world, policy makers have become increasingly coordinated. Central banks around the world cut or hike interest rates and expand or contract their balance sheets broadly in unison (with some outliers, of course).
I believe this is a form of shadow volatility compression, but that’s a topic for another day.
We can see this visualised below:
The above chart shows the percentage of central banks cutting or hiking interest rates, as well as the net proportion of rate cuts.
Observe how choppy the period was prior to 2000 and how progressively more cyclical this has become since then.
Now look a the two charts below which highlight developed countries' interest rates and central bank year-end (2024) expectations:
The first chart shows that, since 2008, the largest central banks have generally moved in line with one another, largely preserving interest rate differentials (that is, the difference between the interest rate in one country vs. another). The second chart cements this: over the past 18 months, five of the largest central banks in the developed world have shifted their year-end rate expectations almost in lock-step. We can see quite clearly that the western central banks all expect to have a different year-end rate, and yet the interest rate differentials don’t really change much across these expectations.
Now, below we can see how M2 Money Supply of Major Central Banks has evolved over the past thirty years. The most important part here is the cyclical nature of the year-on-year M2 growth. Even prior to 2008, we have these regular multi-year cycles in M2 growth, with growth rates across four major central banks (the Fed, ECB, BoJ and PBoC) rarely slipping into negative territory but consistently expanding and contracting.
Only three more charts to work through and we’ll return to Graham, I promise.
Now that we’ve looked at broad coordination between interest rate cycles globally and cyclicality of M2 money supply growth rates, let’s conclude with a look at central bank balance sheets.
This first chart highlights the total assets in USD of the Fed, ECB, BoJ, PBoC, BoE and SNB. It also showcases the year-on-year expansion and contraction in these total assets.
It effectively mirrors the post-08 period in the M2 growth rate chart above, as one might expect.
Lastly, we can see the individual central bank balance sheet expansions and contractions in USD, with the Fed, PBoC, ECB and BoJ most clearly visible in the first chart due to the size of their balance sheets, followed by the BoE, SNB, RBA, Bank of Canada and RBI in the final chart:
Again, there has been broad coordination in expansion and contraction of their individual balance sheets; not identical, but certainly correlated.
‘But Nik, what does any of this macroeconomic textbook rubbish have to do with financial deepening and what, in turn, does that have to do with my shitcoins?’
Well, returning to Graham and his armchair, what he should really be concerned with is monetary debasement.
Monetary debasement is the process by which the unit value of a currency is reduced, usually by central banks increasing the supply of said currency. It is a tool of financial repression – a shadow tax on savers and a mechanism of wealth transfer to borrowers. By rapidly expanding the money supply (M2) faster than the value of goods and services in the economy (GDP), the unit value of the currency is eroded: the saver loses purchasing power over time and the borrower (including the government) repays debt with currency worth less than when they originally borrowed.
M2 growth outpacing GDP growth… now where have we seen that before?
Yeah, it’s a measure of financial deepening. Monetary debasement is complicit in perpetuating financial deepening:
You expand the money supply but the economy does not grow at the same rate → there is now more nominal currency chasing relatively fewer goods and services → savers lose purchasing power over time as consumer inflation picks up due to the aforementioned dynamic → but there is still surplus nominal currency; so where does it go?
Well, as mentioned in the introduction, given that we are talking about global financial deepening, we mean growth in global M2 is outpacing growth in global GDP (measured in Dollars). This means that the nominal pool of currency in circulation outpaces the growth in goods and services to which that nominal pool can be directed, across the world. You cannot consider imports because we have already accounted for global GDP.
So, you have only three outcomes of this dynamic: consumer inflation, hoarding and speculation.
Consumer inflation is where the prices for goods and services rise globally, as outlined above. Nominal pool of currency grows faster than the goods and services it can purchase = some degree of price inflation.
Hoarding is where individuals and businesses just save the nominal growth in currency (the surplus liquidity). This often occurs during times of severe economic distress and uncertainty. After all, why would businesses spend or invest surplus liquidity if they have a poor outlook for the near-term future? See Japan in the 1990s…
Speculation. This is where the magic happens. Speculation is the most likely outcome (and I will explain why below) and the one that has occurred consistently during times of global money supply outpacing global GDP growth, post-2008.
As a quick aside, in the 1990s, Japan employed monetary debasement but did not get consumer inflation or much speculation. Instead, the Japanese hoarded that surplus nominal currency given the poor economic outlook and deflationary dynamics, even despite incentives to spend, borrow and invest such as near-zero interest rates.
But we are talking about a much more globalised – and coordinated – economy than the 1990s, particularly so post-2008.
As we found from the above charts, central banks have been coordinating for over two decades.
(And below, we can see how things changed in the US in the late 90s, prior to which Velocity of Money (or GDP/M2) was relatively flat for decades, before ramping up to a peak in the mid 1990s and subsequently collapsing, as a new multi-decade trend emerged of M2 growth outpacing GDP growth. This has been monetary debasement on steroids for the best part of thirty years.)
So, we’ve established that there are three primary outcomes when global M2 growth outpaces global GDP growth: consumer inflation, hoarding and speculation.
The first one is self-evident: if the world has a larger pool of currency to purchase the same amount of goods and services, there will be some degree of inflation. We can see this correlation below:
The black line is YoY M2 growth in the United States vs. the red line which is YoY Inflation.
Most of the time, and particularly since the late 90s (interestingly enough), YoY M2 growth has far surpassed YoY inflation.
This is where the monetary debasement leads to financial deepening.
We now have a larger pool of nominal currency with 'nowhere' to go.
It can be hoarded – but given the global coordination by central banks to keep interest rates low (and real rates – that is, the nominal interest rate minus the inflation rate – as close to zero as physically possible) there’s not a huge incentive for that, though we do see gross savings as a % of global GDP continuing to climb, suggesting that some of that nominal currency does continue to be hoarded:
And now for the fun part…
The surplus nominal currency has only one place left to flow to: assets.
If it’s not buying goods and services globally, and it’s not being hoarded, the surplus nominal currency by definition must be allocated to assets.
Let me illuminate this with some charts, looking at Global M2 / Global GDP vs a handful of our favourite assets (though I won’t reshare the S&P 500 & Nasdaq 100 charts from the beginning of this post):
BITCOIN:
ETHEREUM:
GOLD:
COPPER:
WINE:
REAL ESTATE:
LUXURY GOODS:
ALTCOINS:
Yes, equities and crypto particularly love periods in which Global M2 is outpacing Global GDP as they heavily benefit from the surplus liquidity flows, but even cyclical commodities have significant correlations for extensive periods with this phenomenon, as do assets like real estate and wine and even luxury goods (though one could argue that these latter two are both assets & goods & services).
Nonetheless, this is demonstrative of the concept that periods of financial deepening – which expand and contract somewhat cyclically – correlate with returns in all sorts of assets.
This is most clearly expressed in altcoin dominance:
What we are seeing here is that the profligacy of global monetary policy continues to fuel speculative bubbles, with altcoins being the most sensitive to these contractions and expansions in the cycles of Global M2 / Global GDP.
At the tail ends of these cycles, where Global M2 growth is significantly outpacing Global GDP growth, there is simply too much surplus liquidity sloshing around to be allocated ‘efficiently’: it has already purchased goods & services and contributed to global consumer inflation; it has already been hoarded; it has already been allocated global equities and commodities and hard assets like Bitcoin – it needs an escape valve, and the broader crypto market provides one.
And going back to our idea that valuation distortions are a feature not a bug of this phenomenon, this also explains why we see progressively more absurd valuations whilst fundamentals do not catch up. The gap between fundamentals and valuations has grown wider and wider over the past three decades precisely because the currency that assets are priced in is being debased exponentially via expansion of the global money supply, whilst global GDP is not growing at the same rate (which is what drives the fundamentals, like earnings, for example):
We, in some sense, have put a floor on PE ratios at levels that in the previous century marked tops (20-25), with a general trend of higher lows. This is suggestive of that ever-widening gap between fundamentals and valuations that is made possible by financial deepening.
In fact, if we look at OTHERS/QQQ, which can be considered something of a proxy for valuation absurdity, we see something similar:
Altcoins significantly outperform the Nasdaq 100 when Global M2 is outpacing Global GDP and then tend to underperform when the trend shifts.
And if we look at the Velocity of Money (that is Global GDP / Global M2 – or simply the inverse of the above), we can see it is broadly correlated with Bitcoin Dominance + Stablecoin Dominance:
This demonstrates that when global GDP is expanding fasting than global M2, Bitcoin + Stablecoin Dominance tends to also rise, suggestive of risk off, likely because there is less surplus liquidity flowing to assets and more being used to purchase goods and services and/or being hoarded. And vice-versa: when the velocity of money falls (that is, global M2 begins to outpace global GDP again), Bitcoin + Stablecoin dominance also falls.
In fact, when there is a mismatch here, like in Q4 2020 where velocity of money was falling rapidly but Bitcoin + Stablecoin Dominance was rising, I would view that as a clear opportunity to be more heavily allocated into risk, anticipating risk to play catch up over the subsequent months.
So, wrapping this up, we have established that monetary debasement occurs when global M2 growth outpaces global GDP, which in turn facilitates financial deepening due to surplus nominal currency that is not contributing to consumer inflation or being hoarded instead flowing to assets, with risk appetite growing as the rate of financial deepening steepens.
This has occurred in relatively consistent cycles since the late 90s, particularly so post-2008, which has led to asset prices reaching historically high valuations relative to their fundamentals, which have not kept pace due to the aforementioned phenomenon.
This is likely to continue to occur for the foreseeable future because we live in a globalised and coordinated economy, where worldwide monetary debasement allows for a shadow tax on savers and a wealth transfer to borrowers (including governments), perpetuating debt cycles. The side effect of this is a near-perpetual bid that puts a floor under asset prices, which particularly benefits crypto as the most sensitive asset to financial deepening cycles, but also leads to periods of significant underperformance when Global M2 / Global GDP is contracting.
In short, as the great @cryptopathic has stated in no uncertain terms, ‘the denominator is worthless.’
Whilst those dynamics continue to be in play, making the most of these cycles by heavily allocating to assets when Global M2 / Global GDP is in deep contraction and subsequent sideways makes sense. Derisking /exiting is a more complicated process, but I have another post I will be publishing for how you can actually tactically play these broader cycles and what to look for as exit indicators.
With some luck, this has given you a clearer understanding of the dynamics that perpetuate these speculative cycles, particularly over the past thirty years.
And I’ll leave you with this final visual that I think ties things together beautifully:
