The Uncharted Territory of Falling Bank Reserves
By Adam Thurgood on July 27, 2023
The Covid lockdown and subsequent reopening have led to a lot of unprecedented economic outcomes and data distortion. In fact, there has been an unprecedented use of the word unprecedented! Needless to say, analyzing economic data in a post Covid world is much trickier than it has ever been. Take for example, the reading of “other deposit liabilities”, or “ODL.” This is essentially a metric that shows how much banks have parked at the Fed, which matters a great deal for markets. The chart below shows the S&P 500’s 200-day moving average (blue) with ODL (orange).
The move lower in ODL hasn’t just been negative, it has been historic. Over the past 50 years, ODL has rarely gone negative year-over-year and has come nothing close to the depth and duration of the current decline. This is a serious and prolonged decline in bank reserves. The impact the decline in money supply could have on markets is difficult to grasp, given the lack of historical examples to draw from. Money is the gas that propels the system forward and taking away the fuel could spell trouble.
Since late March, the relationship between ODL and the S&P 500 seems to have broken down. The S&P 500 has surged higher while ODL has continued to fall. Over the past decade, the correlation of monthly values between the S&P 500 and ODL is a whopping 97%. Thus, the divergence we’ve seen since March is completely out of whack.
If we assume the relationship comes back in-line, we are left with two paths forward:
- Bank reserves surge higher and catch up with the move in stocks – this seems unlikely given the backdrop of the Fed continuing its quantitative tightening program, which sucks capital out of the system.
- Stocks retreat back towards levels more consistent with ODL – this seems more likely than option 1. On a relative strength basis, the S&P 500 is overbought and due for a correction.
There is one giant caveat. The S&P 500 is essentially driven by seven large tech stocks, which are showing no signs of weakness. Until they crack, the divergence between ODL and the S&P 500 could continue to widen. In my view, this will only inflate the risk that is already present and set us up for an even more painful resolution down the road.
