The Impact of Money Supply Changes on Financial Markets

Money supply is the total amount of money in circulation. Depending on what kind of funds are taken into account, the money supply is divided into certain monetary aggregates:

• M0: cash (banknotes and coins)

• M1: M0 + funds on current accounts (checking deposits and demand deposits)

• M2: M1 + savings deposits + money market funds + certificates of deposit

Including liquid forms of money, the aggregate M2 characterizes money in the broadest sense of the word. In the long run, the money supply tends to grow, with growth moving from linear to exponential in recent decades. This is due to the huge volumes of liquidity pumped into the global financial system from the 2008 crisis to the present.

Despite the persistent uptrend of the aggregate M2, in the short term, the money supply can either increase or decrease. The decrease occurs in 23.2% of cases. In this study, we will consider whether it is possible to use data on changes in the value of the money supply for trading in financial markets.

Strategy

Entry into the market - at the opening of Tuesday after the publication of data on the M2 aggregate on Mondays.

Exit from the market:

• On Friday of the 1st week (market entry week)
• On Friday of the 2nd week
• On Friday of the 3rd week
• On Friday of the 4th week
• At the opening of Tuesday when the opposite signal appears

If Friday is a day off, exiting the trade on Thursday of the same week.

When the money supply grows: we buy gold, the S&P 500 index and pairs with the quoted currency USD, we sell pairs with the base currency USD.

With the money supply decreases: we sell gold, the S&P 500 index and pairs with the quoted currency USD, we buy pairs with the base currency USD.

The strategy will be evaluated according to the following criteria:

• The average rate of return reflects the relative change in the quotes of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, a negative one indicates a loss. 

The average rate of return (D) of a financial instrument is calculated using the formula:

D = Σ P (%) / n,

where:

n is the number of trades;

P (%) – the percentage of change in the quote of a financial instrument at the time of fixing a position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%



• The total rate of return (TD) is the sum of the profits from all trades. The greater the value of the total rate of return, the greater the profit brought by the signal during its testing period. 

• Maximum drawdown (MaxDD) is the maximum loss in percentage terms from fixing unprofitable trades for the entire testing period. The lower the value of the maximum drawdown, the better the trading signal works.

MaxDD = | min ( DD₁: DD_n ) |

DD_n = TD_n – max ( TD₁: TD_n )

where:

n – number of trades;

D – rate of return;

TDn – total rate of return of n trades;

DDn – drawdown at the time of closing the n-th trade;

MaxDD – maximum drawdown.

Analysis of the obtained results

Let's consider the results of the strategy with an exit on the 1st, 2nd, 3rd, 4th weeks after entering the trade:

With exit options on the 1st and 2nd weeks after entering the trade, the considered financial instruments have not shown a rate of return exceeding a significant level of 0.3%.

Currency pairs also have not shown a significant level of rate of return when exiting trades on the 3rd and 4th weeks after entry.

Gold has shown a significant rate of return of 0.33% when exiting trades on the 4th week after entry.

The S&P 500 index has shown significant rates of return of 0.38% and 0.44% when exiting trades on the 3rd and 4th weeks after entry.

Despite significant rates of return for gold and the S&P 500 index, trading according to the indicated strategy leads to a very high level of risk: the maximum drawdown for gold exceeds 200%, for the S&P 500 the maximum drawdown is 89.57% and 175.69%, respectively.

Further, let’s consider the results of the strategy with an exit on the opposite signal:

In general, the results are similar to the results of the strategy when exiting on the 1st, 2nd, 3rd, 4th week after entering the trade: currency pairs show a negative rate of return, while gold and the S&P 500 index have a positive average rate of return.

The exit on the opposite signal has led to a significant decrease in the risk level of the strategy: the maximum drawdown for gold has decreased from 200.43% to 101.38%, but this is still a very high figure. For the S&P 500 index, the maximum drawdown has decreased from 175.69% to 59.12%. This drawdown level would be considered acceptable, but the average rate of return (0.18%) of the strategy does not compensate for such a risk with a significant level of profitability.

Detailed results are shown in the Appendix:

XLSX (0.07 MB)The impact of money supply changes on financial markets.xlsx