Why Investors Must Follow M2: A Comprehensive Guide from Central Bank Policies to the Crypto Market

Key Points of the Quick Read Version

• What is M2: The money aggregate M2 represents the total amount of money available in the economy, including cash, checking accounts, savings accounts, and money market funds.
• Why it matters: M2 growth directly affects investors' asset allocation choices, whether it's stocks, bonds, or cryptocurrencies.
• Market Reaction: When M2 grows rapidly and interest rates are low, risk assets (including cryptocurrencies) typically perform well; and vice versa.

Basic Knowledge of M2 That Investors Need to Understand

The monetary aggregate M2 is not a mysterious economic term, but a concrete indicator that affects your investment decisions. Simply put, it measures how much “spendable money” is in the economy.

Imagine the economy as a swimming pool. M2 is the total amount of water in this pool, including the water that is immediately available (cash and checking accounts) and the water that can be quickly poured in (savings, time deposits, and money market funds). When the water in this pool increases, people tend to spend more money, driving the market up. When the water level falls, the economy begins to contract.

The Actual Composition of M2: Understanding Your Market Environment

To truly understand how the М2 money aggregate affects your investments, you need to know what it includes. The main components that the Federal Reserve considers when calculating М2 are:

First Layer: Most Liquid Funds (M1)

This is money that can be accessed immediately:

• Cash in the wallet and demand deposits on the bank card
• Checks and traveler's checks (although they are not common today)
• Other available check deposits for payment

The characteristic of this layer is the highest liquidity, the lowest risk, but also the lowest return.

Second Layer: Prepared Currency Assets

These funds cannot be used immediately but can be converted to cash within a few days:

• Savings Account: The bank pays interest, but may limit the number of withdrawals.
• Certificate of Deposit (CD): Customers lock in funds for a period of time (usually less than $100,000) in exchange for higher interest.
• Money Market Fund: A type of mutual fund that invests in short-term, low-risk assets, typically offering higher yields than savings accounts.

How M2 Growth Drives Market Cycles

To understand the relationship between the monetary aggregate M2 and the market, you need to see a simple causal chain:

M2 Expansion Phase → Available funds increase → Consumption and investment activities rise → Asset prices increase

When the central bank lowers interest rates or the government increases spending, M2 begins to grow. Banks find it easier to issue loans, businesses find it easier to borrow money to expand, and consumers are more willing to purchase homes or cars. All of these activities inject more funds into the economy.

On the contrary, when M2 growth slows down or contracts:

M2 Contraction Phase → Available funds decrease → Consumer spending declines → Asset prices fall

This is why investors closely monitor central bank policy decisions. When the Federal Reserve announces an interest rate hike, the market often declines, as investors expect M2 growth to slow.

The Four Forces Driving M2 Changes

1. Central bank's monetary policy decisions

The Federal Reserve directly controls M2 by adjusting the benchmark interest rate. Lowering the interest rate makes borrowing cheaper, encouraging banks to issue more loans to businesses and individuals. This will increase M2. Raising the interest rate has the opposite effect—it makes borrowing more expensive, discouraging the issuance of new loans and slowing M2 growth.

2. Government's fiscal policy

When the government issues stimulus payments or increases spending, new funds enter the economy. During the COVID-19 pandemic in 2020, the U.S. government's stimulus program directly increased M2, leading to a year-on-year growth of M2 of 27% in early 2021 - a record number.

3. Lending behavior of the banking industry

Banks are the creators of M2. Whenever they issue a loan, they are essentially creating new money in the economy. If banks significantly reduce lending (for example, during a crisis), M2 growth will stagnate.

4. Consumer and business behavior patterns

Sometimes the changes in M2 are not driven by policy but by the decisions of market participants. When people feel insecure, they may stop spending and put money into savings accounts. This will change the growth trajectory of M2.

M2 and Inflation: The Relationship Most Concerned by Market Participants

There is a disturbing connection between the money aggregate M2 and inflation, which explains why central banks are so vigilant about M2 growth.

The basic logic is simple: when there is too much money chasing too few goods, prices rise. If M2 grows at a rate that exceeds economic production capacity, inflation will accelerate.

2022 was a perfect case. The Federal Reserve allowed M2 to grow significantly in 2021, partly due to supply chain disruptions caused by the pandemic. The result? Inflation hit a 40-year high. By 2022, the Federal Reserve began aggressively raising interest rates, leading to negative growth in M2 — which had a significant impact on the market.

How M2 Changes Your Investment Choices

This is why the monetary aggregate M2 is so important to traders and investors. Different asset classes react differently to changes in M2:

cryptocurrency market

During periods of strong M2 growth and low interest rates (the so-called “cheap money” era), cryptocurrencies tend to perform well. Investors seeking higher returns shift their funds from traditional banking products to Bitcoin, Ethereum, and other tokens.

But when M2 begins to shrink and borrowing costs rise, the situation reverses. Investors sell off risk assets and turn to safe assets. The cryptocurrency market is usually the first to be affected. This is why the prices of Bitcoin and other tokens are highly correlated with M2 growth.

stock market

The stock market's reaction to M2 changes is similar. When M2 grows, corporate financing costs are low, profits are ample, and the stock market rises. When M2 contracts, businesses cool down, and the stock market falls.

Bond Market

Bonds are often viewed as a safe haven. When M2 is growing and interest rates are low, investors seek higher-yielding bonds. However, when interest rates rise, the value of existing bonds declines (because newly issued bonds offer higher interest), causing bond prices to fall.

The interest rate itself

Interest rates and the growth direction of M2 often move in opposite directions. When the central bank believes that M2 is growing too quickly, they raise interest rates to cool the economy. When M2 growth stagnates, they lower interest rates to stimulate borrowing and spending.

Real Case: Explosive Growth of M2 During the COVID Era

In the spring of 2020, the global economy was paralyzed. The U.S. government responded swiftly:

• Distribute direct stimulus payments to residents
• Expand unemployment benefits
• The Federal Reserve lowered interest rates to near zero

What is the result? M2 has grown at an unprecedented rate. By the beginning of 2021, the year-on-year growth rate of M2 reached 27%.

The massive expansion of M2 this time has driven up the prices of almost all asset classes—stocks, real estate, and of course cryptocurrencies. Bitcoin and Ethereum reached historical highs in 2021 largely due to the excess liquidity prompting investors to seek risk assets.

But the story of 2022 is completely different. The Federal Reserve began to aggressively raise interest rates to combat inflation. M2 growth slowed and then turned negative. This shift marks the beginning of a new era— all asset classes began to decline. Cryptocurrencies suffered the deepest losses.

Why Investors Should Monitor M2

As an investor, why should you care about this? Because the М2 monetary aggregate is one of the most forward-looking economic indicators. It often signals changes 3-6 months before the onset of an economic recession or boom.

When M2 grows rapidly, it usually indicates that a period of rising asset prices is approaching. When M2 growth slows down or turns negative, caution is necessary — the market may face a correction.

Central banks use M2 to formulate policies. Governments use M2 to plan expenditures. Smart investors should also use M2 to guide their allocation decisions.

Summary: M2 is the pulse of the market

The monetary aggregate M2 is far from an obscure economic statistic. It is a real-time reading of the health of the economy and financial markets.

When M2 grows, it usually indicates more job opportunities, increased spending, and higher asset prices. However, it can also lead to inflation risks. When M2 stops growing or begins to contract, the economy typically falls into distress, and asset prices decline.

Understanding M2 and how it affects different asset classes is key to becoming a more savvy investor. Whether you are trading cryptocurrencies, stocks, or other assets, monitoring M2 should be a part of your analytical toolbox.