One of the reasons that stock market has been up for the past two months is massive liquidity injection by the European Central Bank—exactly the way the market was charged by quantitative easing in the US in 2009 and mid-2011. Are there signs that liquidity injection by ECB is about to halt? In that case, will the market continue to move higher?

The Sensex has been up a sharp 15.4% since 7 January 2012, mainly due to massive inflow of money from foreign institutional investors (FIIs). FIIs have put it as much as Rs22,989.95 crore in January and February this year so far; over the first quarter of 2011, when they had pulled out Rs7,931.11 crore. Why the sudden inflow of investment? Where is the money coming from? While we would like to believe suddenly the foreigners have rediscovered the hidden charms of India, the fact is that a lot of this money has is coming from short-term traders who are taking advantage of massive liquidity injection by the European Central Bank (ECB) to trade in risky assets like emerging market equities.

The total amount the ECB has spent since starting the programme, back in May 2010 remained at 219.5 billion euros, with just 59 million euros last week. The ECB and the 17 Eurozone national central banks buy the bonds under what the ECB calls its Securities Markets program (SMP). European laws forbid it buying the bonds direct from governments, but it gets round the restriction by buying them from banks and other investors on the open market.

This parallels that of the liquidity injection programme of the US Federal Reserve of 2009-11. Whenever there have been injections by central banks equities have started to shoot up. The graph below highlights how central bankers’ liquidity injection programme has pushed up the markets at different times in the last three years.

You can see how markets have expanded significantly, since 2009, shortly after the sub-prime bust, after the US Fed introduced the first of its Quantitative Easing (also known as QE1). QE1 is part of the broad monetary policy of printing money and dumping it on the economy vis-a-vis banks. This leads to a ‘loose money’ policy, as banks now have more money to lend. The hope is that with higher bank lending, economic activity would pick up. But if there are no takers for more bank loans, the money goes into speculative purposes like funding hedge funds or the bank’s own trading departments, which in turn leads to widespread purchase of financial instruments, such as stocks or gold or commodities. This is what has propped the markets up with each quantitative easing. Some of this money eventually finds its way to emerging markets, like India. Notice that after the first QE1 ended, the markets fell. Immediately, the Fed panicked and introduced QE2. The markets reacted positively and moved upwards, until it sagged again, at the end of QE2. Incidentally, after this, the ECB then stepped in and announced it would buy Euro Bonds. Not surprisingly, the markets took the good news and climbed back up. As the bond buyback eased towards its end, the US Fed ‘hinted’ at QE3. It remains to be seen whether it will announce it.

What do we notice from this chart? What we see as bull or bear market is only partly linked to fundamental factors. A bigger factor is whether large speculators will access cheap money or not as and when the two big central banks decide to loosen their purse strings. If they are easing, the market stabilises and rises. If the easing ends, the market sags. Interestingly, according to some savvy traders like Eric Schwarts, who runs a great blog called marketanthropology.com, the ECB has halted its bond buying programme for the first time since early August. Is that signal that the Indian markets are about to give up some of the huge gains of the Jan-Feb period?