“Equity funding is the canary in the coal mine for a reset of investor perception about financial conditions,” said Martin Tobias, a strategist at Morgan Stanley. His concern is the price of the borrowed money that has helped carry US stocks higher this year.
Several things are squeezing the banks that provide that financing. Money is flowing into leveraged exchange-traded products, stock options volumes are rising and hedge funds hold record exposure. Together they are straining the balance sheets of the large banks that offer equity financing, and the loans behind much stock trading are costing more as a result.
Primary dealers, the banks that deal directly with the Federal Reserve, now carry record equity repo exposure of more than US$220-billion. Repo, short for repurchase agreement, lets a trader borrow from a bank for as little as a day against securities and buy them back when the loan comes due. Some measures tracking the gap between implied financing rates on S&P 500 total-return futures and benchmarks such as SOFR show costs at a record in data back to late 2020, setting aside year-end periods that are usually distorted by funding squeezes.
Where the demand comes from
Assets in US-domiciled leveraged exchange-traded products roughly doubled over the last few months, to around US$200-billion, led by technology and semiconductor products. Options added to the load. Investors who had cut risk during the recent Iran war rushed to buy upside exposure once a ceasefire arrived, and the surge in call-option activity put more pressure on dealers.
The Nasdaq Composite has logged 20 record closes this year as AI spending on chips and other goods lifts profit growth and investors stay confident the economy can avoid a recession.
Barclays estimates that if the equity financing market is around US$10-trillion, a 10 per cent rise in equities creates roughly US$1-trillion of extra financing demand. That could add US$150-billion to US$200-billion of risk-weighted assets for the banks that handle those trades.
Treasury repo has stayed accommodative. Samuel Earl, a US rates strategist at Barclays, said this year’s changes to the Supplementary Leverage Ratio gave large banks more room for government bond trades. Equity financing is different, he said: it uses more capital and liquidity under bank rules, has stricter counterparty limits and lacks the central clearing that lets dealers net Treasury repo positions.
Two readings
Not everyone sees danger. Stefano Pascale, head of US equity derivatives strategy at Barclays, called higher financing costs a sign of confidence. “The cost of financing going higher typically coincides a little bit with periods of euphoria,” he said. “The cost of financing going higher is not, per se, a problem for the market.” The pain, he added, falls mainly on trades that depend on cheap financing, where some leveraged investors may have to pull back.
Tobias is more cautious. He said peaks in stocks have lined up with highs in equity financing costs, and that expensive funding could make some leveraged trades too costly to try. Only one of the 11 S&P 500 sectors has beaten the broader index over the past three months, Information Technology, where semiconductors and equipment make up roughly half the weight. Micron shares have more than tripled this year.
With funding pressure building toward quarter-end and the S&P 500 struggling to move past its 7,621 high on June 2, Tobias said the market could be at an inflection point. “What’s propelling the market higher isn’t a broader reflection of the outlook for the U.S. economy,” he said. “It’s simply leverage that’s being concentrated in one very narrow part of the market.”
Andy Constan, founder and chief investment officer at Damped Spring Advisors, noted that rising asset prices have become a key support for consumer spending while real wage growth is weak. “If the stock market just stays where it is, that influence disappears,” he said.
