Leverage That Fueled US Stock Rally Becomes a Growing Concern

The leverage that helped fuel the US stock rally is now becoming an increasing source of unease. The surge in market leverage, stemming in part from the massive growth of levered exchange-traded products, retail margin accounts and hedge fund deposits at prime brokers, is stoking worries that it may exacerbate the next crisis. The demand to borrow money has driven an unusual mid-year spike in financing costs, which have reached the highest levels since December 2024. “Leverage has become one of the defining themes for investors,” said Andy Kent, a broker at Kyte. “Margin debt is elevated, borrowing across parts of the shadow banking system continues to expand.” The leverage is growing along with uncertainty over the path of equities, inflation and interest rates. That’s fueling demand from investors for cross-asset hybrid option hedges. Still, general market measures of volatility are showing little fear of a massive selloff, even amid tremors in the artificial intelligence stocks that have dominated the stock market this year. Financing Costs Equity financing costs have jumped unexpectedly with the greater demand to hold leveraged positions, as well as additional need to make room for huge initial public offerings. Typically, the costs tend to rise around the end of the year as banks manage regulatory capital and balance sheet usage. CME Group Inc.’s S&P 500 Index adjusted interest rate total return futures have climbed to levels last seen in late 2024, when a similar combination of large long futures positions and a sustained market rally was exacerbated by banks’ year-end constraints. “The cost of funding for US markets has exploded, reflecting a perfect storm between leveraged ETF growth, extended long futures positioning, IPO/ADR programs tying up bank capital and prime brokerage growth,” said Kent. One risk of the high leverage is that it can exacerbate swings, making the market more fragile. “Together, they increase the market’s sensitivity to liquidity shocks, raising the risk that relatively modest moves become self-reinforcing,” Kent added. Cross-Asset Hybrids Concern that higher interest rates will strangle the record rally in tech stocks as inflation bubbles up has some investors hedging with dual binary and other “light” exotic options. Banks are seeing healthy customer flows on both sides of the major macro themes across popular cross-asset pairs. “Initially, investors were playing the stagflation scenario of equity down, rates up, which put pressure on the implied correlation on the pair,” said Raphael Cyna, global head of payoff structuring at Bank of America Corp. That attracted some traders to put on the reverse trade, to play “equity down, rates down as a very cheap, recession hedge where bonds act as the more traditional safe haven,” he added. Banks are continuing to market new variations on the hybrid structures. JPMorgan Chase & Co. strategists led by Bram Kaplan recently recommended S&P 500 call options contingent on higher interest rates, a trade that allows investors to take advantage of the correlation between the two nearing multi-year lows. Muted Volatility Despite multiple declines of more than 1% in the S&P 500 during June and even bigger swings in the Nasdaq 100 Index, Cboe Volatility Index gains have been short-lived. So far this year, buying VIX calls has only paid off in very tight windows if the holder was able to cash in on a spike before the gauge retreated. It may take an increase in implied correlation from the current low levels to drive up the VIX, if a macro shock causes stocks to move more in lockstep. Hedgers are also keeping an eye on seasonality. The VIX tends to decline into the US summer, with July the lowest month on average since 1990. With the VIX closer to 20, “there’s arguably more room to fall if and when the market recovers,” said Matthew Thompson, co-portfolio manager at Little Harbor Advisors. In one of the group’s trading positions, “we’re actually short volatility still and have added slightly,” he added.