A Combustible Mix: Hidden Leverage, Global Liquidity Downtrend and Low Stock Market Volatility
By the Curmudgeon
Financial Stability Board Report:
The Wall Street Journal reported on Thursday that global financial regulators are warning against hidden leverage in the financial system, cautioning that a build-up of borrowed money among non-bank institutions could leave markets vulnerable to widespread stress and financial disruption.
The Financial Stability Board (FSB), a global body that coordinates financial regulation for the G20 countries, stated in a September 6th report that hedge funds are operating with high levels of synthetic leverage, which is when derivatives are used to create exposure to certain assets.
In the week ending September 8th, 2023, the FSB warned that leverage is now very high in parts of the $7 trillion hedge fund sector, while noting that significant data gaps make it very difficult to get a full picture of vulnerabilities among "non-banks."
That opaqueness is because hedge funds spread their borrowing across banks that provide them prime-brokerage services, making it difficult to assess a fund's full leverage. The small concentration of prime brokers that lend to hedge funds could amplify shocks in the financial system, the report said.
If not properly managed, the build-up of leverage creates a vulnerability that, when acted upon by a shock, can propagate strains through the financial system, amplify stress and lead to systemic disruption.
This has been previously demonstrated by a series of financial incidents, stretching back to the 1998 collapse of Long-Term Capital Management, the 2008 global financial crisis, the March 2020 market turmoil, the 2021 Archegos failure, and the September 2022 dislocation in the UK gilt market.
Leverage is a two-edged sword which amplifies both rises and falls in financial assets. Hence, hedge fund leverage needs to be watched closely.
Leverage Effect on Equity Markets:
Hedge fund leverage may explain why global equity markets have been so strong this year with low volatility (more below). Thats despite net redemptions from mutual funds, insider selling, interest rate increases across the entire yield curve, and the Feds QT (which has reduced its balance sheet from $8.734 trillion on March 23rd to $8.11 trillion last week).
Global Liquidity Update:
We noted in an earlier Curmudgeon post that global liquidity had flat lined. In a September 6th update, Cross Border Capital noted a small uptick in global liquidity to $164 trillion, but a short-term downtrend is still evident. That should constrain world risk assets, the firm added, noting that global liquidity drives financial markets.
The chart below, courtesy of Cross Border Capital, depicts the MSCI World equity index vs. Global liquidity:
U.S. Stock Market Volatility Remains Low:
After big gains for the first seven months of the year, the U.S. stock market has wobbled since August. Volatility has collapsed with the VIX well below its long-term moving average of 21.4. It closed at 13.84 on Friday, not much above its 52-week low of 12.73. High levels of the VIX (normally when it is above 30) can point to increased volatility and fear in the market. Thats certainly not the case now.
In particular, there havent been any big selloffs this year (unlike 2022). Through September 8th, theres not been a single loss of at least 1.5% in the S&P 500 in the 94 trading sessions since late April. Thats the longest streak since 2018, as depicted in this chart:
Peter Cecchini, director of research at Axonic Capital said, Enough people were wrong about this years rally that they got tired of spending money to protect against future losses. But we dont know how much longer the AI narrative will be able to carry stocks broadly higher.
Be well, success, good luck and till next time
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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