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Leverage is cyclical

March 30, 2021

Graph depicting median annualized changes in margin account balances across the business cycle

Source: FINRA and New York Stock Exchange

Equities got off to a shaky start yesterday after Credit Suisse and Nomura both indicated that they faced “significant” losses stemming from Archegos’ failed margin call and forced liquidations late last week. While the market bounced back in the late morning and afternoon, there are two key lingering risks here. The first, and more near-term concern, is that the scope of the losses is still uncertain and could be larger and broader than even the sizeable pullbacks in the affected stocks are pricing in. The bigger and more pernicious risk, however, is that this episode fuels a tightening of margin requirements, leading to a much larger deleveraging.

Historically, however, margin debt has rarely fallen for any appreciable length during economic expansions. In fact, margin balances typically do not begin declining until roughly one year before the onset of recessions and, even though they tend to rise more slowly as the cycle matures, have in only one case in the last five decades turned in a sizeable pullback before an expansionary peak (this was at the tail end of the 1970-73 cycle, when the Fed was tightening aggressively). In contrast, margin debt falls sharply during recessions, especially during their middle stages. It should come as little surprise, of course, that a form of credit is a function of the business cycle; credit is a driver of economic growth, but is itself driven by the monetary policies that give rise to turns in the cycle in the first place.

Moreover, big gains in margin balances often come in bunches — note the nine double-digit percentage increases across the 1990s, for example — when the underlying economic cycle appears sustainable and interest in the equity market broadens. Those conditions are undeniably in place at the moment and given that margin accounts just started perking up again last year after stagnating in 2018 and 2019, it is likely that there is significantly more upside ahead.

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