When a bank makes a loan, it provides money for commerce and greases the gears of our economic machine. But this increased liquidity for the economy does not necessarily translate into increased liquidity for the stock market.

Why? Because banks typically do one of two things with their funds: buy investments—usually bonds, like U.S. Treasuries and agency securities—or make loans to consumers and businesses. Banks would rather make loans since they tend to yield more than investments like government bills and bonds. So, as loan demand grows, banks begin to sell their lower-yielding investments to fund higher-yielding loans.

The result: money that would have gone into financial assets gets loaned out instead. And as banks sell their investments to fund loans, bond prices fall, and yields rise. This upward pressure on interest rates is generally bad for the stock market.

For example, the chart above shows the year-to-year change in the ratio of bank investments to bank investments plus loans (red line, bottom clip). When this line has been rising, and above zero, it’s typically been a sign that liquidity is rising. In other words, banks are making more investments and fewer loans. This reduced pressure on interest rates is bullish for the stock market. Historically, the S&P 500 (blue line, top clip) has done well in this sort of environment, returning roughly 10.2% per year, on average.

However, when the line is falling and gets below zero, stocks do less well. In fact, a year-to-year change in liquidity below -5.4% has resulted in outright negative returns for stocks.

What is the indicator saying about banking liquidity now? Well, the current year-to-year change in liquidity is 6.8%. In other words, banks have generally increased their investments relative to loans over the past year. Historically, this has been a bullish liquidity environment for stocks.

That’s the good news.

The bad news, however, is that liquidity has come down sharply in recent months. Not too long ago, the year-to-change in liquidity was higher than 22%. As I stated earlier, it was 6.8% last month. This large drop was primarily due to the fact that bank lending is seeing some of its fastest growth rates in years. Over the past three months, consumer loans have been grown at a 23% annual rate.

The problem, though, is that loan growth tends to lead inflation by around a year. Loan growth is something the Federal Reserve can control. So, the implication is that the Fed may need to hike rates even more than the market currently expects. This could put even more downward pressure on stock prices in the months and years ahead.


This is intended for informational purposes only and should not be used as the primary basis for an investment decision.  Consult an advisor for your personal situation.

Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.

Past performance does not guarantee future results.