Fed Succeeds In Driving Investors To Take On Risk And Go Up Risk Curve, But End Game Is Bound To Be Painful Regardless

Last March, the Fed essentially urged investors to take on risk and go up the risk curve. They have obliged. Leverage is high in the system. This works as long as the prevailing upward momentum is in place. When a reversal occurs, it is bound to be painful. It is a good time to buy some protection, which is cheap.

Last March, as Covid-19 began to create havoc, stocks were in free fall and bonds were getting bid up, the Fed got to work. On March 23, it announced unlimited quantitative easing and also said it would start buying investment-grade corporate bonds, which in April was expanded to also include junk bonds. The S&P 500 bottomed in that very session. Earlier on the 9th that month, the 10-year treasury yield (1.35 percent) had already bottomed at 0.4 percent.

From that low through last Tuesday’s fresh intraday all-time high of 3950.43, the S&P 500 (3906.71) is up 80.2 percent. In late January, there was a mini selloff, and buyers were waiting on a trend line from that low (arrow in Chart 1). This support, which now approximates short-term straight-line support at 3870s, could once again get tested in the sessions ahead.

Investors have heeded the Fed’s call. Last March, the message from the central bank was clear: take on risk and move up the risk curve. They have obliged.

Investor willingness to take on leverage has gone through the roof. In five short weeks last February and March, the S&P 500 collapsed 35 percent. FINRA margin debt declined from $579.2 billion in December 2019 to $479.3 billion in March 2020. Then it shot up. It surpassed the record high of $668.9 billion from May 2018 last November when margin debt rose to $722.1 billion. By January this year, a new record of $798.6 billion was recorded (monthly chart here).

In all of last year, margin debt jumped $198.8 billion, or 34.3 percent; the S&P 500 rallied 16.3 percent. There is a strong relationship between the two, with a correlation coefficient of 0.94 percent (Chart 2).

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