By Jules Rimmer
Investors are using record leverage for S&P 500 exposure
Leverage in the market is dangerously overloaded right now and the funding rate is screaming a warning
The cost of funding a long position in the S&P 500 is spiking alarmingly and investors should pay more attention to this warning sign than they are at present. One experienced trader is flagging the stress visible in equity financing rates and saying there's a complacency from the conviction that the market only goes higher.
The stock-market veteran putting investors on alert is Kevin Muir, author of The MacroTourist newsletter and formerly a derivative trader at RBC Capital Markets and Wintor Capital. Muir published a note Monday in which he highlighted the huge demand to fund long positions in stock, most notably the S&P 500.
Many investors enter into total return swaps with banks, by which they receive the return of a certain asset while the counterparty is paid a benchmark interest rate, like the Fed funds (FF00) or the secured overnight financing rate (SR1C00), plus a spread. The higher the spread, the more leveraged exposure traders own.
Muir confesses that this feature of the market is overlooked by many market players, partly because it's esoteric and seemingly innocuous. His message is clear, though: "It's screaming danger and no one is listening." To underline his point, equity financing costs are roughly where they were during the global financial crisis.
Equity financing costs are spiking towards GFC highs
When Muir sent out his update, that spread had ballooned to around 183 basis points and the trend was also picked up by JPMorgan's derivative strategy team, led by Bram Kaplan. Their note dispatched to clients Tuesday also noted that funding a total return swap for a July 31 expiry on the S&P 500 closed at 183 bps, and they duly observed "stress is most acute at the front end" and "equity financing remains at record non-year-end levels."
It's not just the front end either where the funding stress is apparent. JPMorgan looked across the maturity curve for these total return swaps and found spreads were in the 95th percentile of the last five years. Usually, spreads don't rise this much, except at year-end when banks prefer to rein in their balance sheets.
Most of the leverage is focused on the short-end with July 31 the preferred expiry
This isn't true now, though, Muir cautions.
He says the jump in spreads is explained by banks "who collectively understand the risks are demanding higher rates to facilitate borrowing against equities." He cites a chart produced recently by Goldman Sachs which illustrated the "explosive growth" in levered exchange-traded funds. Two years ago this exposure was calculated around $200 billion. Now it's more like half a trillion.
The tightness in funding, Muir explains, is a result of that explosive demand, not a contraction of supply from the banks. It signals a "market stretched much too far to the upside from speculation" and "a boat that is far too loaded with long positions."
-Jules Rimmer
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