The great deleveraging is underway, but how far do we have to go?

The dirty little secret of global financial markets is leverage and the role it plays in, well, everything.

There is a nearly-infinite universe of investments that makes sense if you can borrow at 0%. That universe is dramatically smaller at 5%.

Right now, we’re somewhere in between.

Margin rates are still somewhere around 1.3% but every time the Fed hikes, that ratchets higher. Fed hikes are also a drag on growth so the underlying investments will also generally perform worse.

So many leveraged investors are asking the question: Do I cut leverage now? Or when I have to pay 4%? And what if the Fed gets even more hawkish and I have to pay 5-6% a year from now?

No one wants to be the last one out the door so here we are. Investors are deleveraging and that’s why we are seeing days with such wholesale selling like Friday when virtually every stock in the US was lower.

Today, we’re seeing some signs of selectivity and that could be good. The question is: Where are we in the deleveraging cycle? There have certainly been some funds that started selling down at the outbreak of the Ukraine war, or earlier. Still, I find it hard to believe that we’re even halfway there, at least in stocks.

The liquidity and bond market crisis at the start of the pandemic illustrated just how many layers of leverage are out there.

FINRA reports retail margin levels monthly and wolfstreet.com offers a good illustration of it. We’ve been trending lower since the peak in October but it was still extraordinary high through the March reading.

There are other types of margin as well, such as Securities Based Lending. Hedge funds can also leverage at the institutional level, which isn’t shown here.

No one really knows how much leverage is out there but it’s clear to me that it’s being scaled down almost daily.