Margin lending: investors are loading up on cheap debt to buy stocks
Central banks will be slow to raise rates, but even small changes matter with US margin debt at record highs
Count me among those who are sceptical about how quickly central banks will raise interest rates. Yes, they’re making noises about doing so – and with inflation high, many analysts suggest they should act faster. But our highly indebted world can’t take high rates and policymakers know that. So while rates should begin creeping off the floor next year, the pace of increases is likely to be slow and they will take advantage of every reason – a new variant here, a wobble in the markets there – to hold back.
In contrast to the negligence central bankers displayed in the 2000s, when their foot-dragging created the housing bubble and the global financial crisis, that may even be for the best. The economy is so troubled that a wage-price spiral that inflates away liabilities may be the least perilous path. But if monetary policy gets at all tighter, it’s hard to see markets shrugging that off.
When we talk about tighter policy, we tend to think of higher rates making other investments less attractive: if you can get 1% on a bank deposit again, a ten-year bond yielding the same becomes a worse deal. But another way in which tightening could hit markets is by curbing the supply of almost free money that has buoyed them.
One obvious example of this is the growth of margin loans (see below) at brokers in the US. This has soared since early 2020, reaching $936bn in October compared with $545bn in February 2020. The same expansion of margin debt happened in the run up to the 2000 tech dotcom bubble and the 2008 financial crisis, but the rise this time has been much more abrupt.
Indicators such as this are not a reliable market timing signal – there isn’t a level that signals danger. If we look at margin debt as a percentage of the S&P 500’s total market capitalisation, it stands at around 2.5%, according to data compiled by the economist Ed Yardeni. In the 1990s, margin debt as a percentage of the S&P 500 market cap was consistently below 2%, except at the peak of the dotcom bubble. Conversely, in the ultra-low rate environment after the financial crisis it was up at around 3% for many years. It only began to drop back towards 2% after the Fed began tightening faster in 2018.
In other words, the market has risen even faster than the growth in margin debt – trends like this are just one part of a bigger picture. Nonetheless, this is an example of how traders have seized on cheap debt in this rally and that may make markets vulnerable to any real tightening. When stocks drop, traders tend to deleverage and that exacerbates the sell-off. The S&P 500 wobbled quite a bit in 2018. The point at which tighter policy causes pain could well be lower this time.
I wish I knew what margin was, but I’m too embarrassed to ask
When traders buy shares or other assets, they sometimes borrow money to fund the purchase. The aim of doing this is to increase their potential returns. Assume a trader buys £100,000 of shares and borrows £40,000 to do so. The shares go up by £6,000, they sell the lot and repay the loan. They are left with £66,000, a gain of 10% on the total capital they personally invested (£60,000), even though the share price only went up by 6%. Of course, it works the other way as well: a 15% drop in the value of the shares would mean that the trader has lost 25% of their capital.
The concept of using debt to fund part of an investment is known as gearing or leverage, but the specific practice of using money provided by a broker is known as buying on margin. The collateral that a trader must provide to protect the broker against credit risk (ie, the risk that they won’t pay back their debt) is known as the margin, and the amount borrowed is the margin loan. In our example, the trader has put up £60,000 in margin and has a margin loan of £40,000. In reality, the collateral is not always new cash paid into the account: the trader may be able to borrow against other stocks.
The amount of margin needed depends on industry regulations, the broker’s own policies, and the asset being traded (trading volatile small stocks needs more margin than trading stable large ones). Exchanges for trading derivatives such as futures set their own margin requirements and may raise these when volatility rises.
The amount of collateral the trader needs to have before starting a trade is known as initial margin. The minimum value of collateral that must then be kept while the position stays open is the maintenance margin. If the value of the collateral drops below the maintenance-margin requirement, the trader must pay in more collateral or their position will be closed. The demand for more collateral is known as a margin call.