Borrowing more 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 (see right). 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.

Rocketing debt

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.

“Margin loans at US brokers are up 71% since February 2020”