Too Much Leverage?

Over the last year or so, I’ve shared with friends a hypothesis that leverage is causing extreme fluctuations in asset prices. I believe it was a material factor in the 2020–2021 runup and that it’s played a significant role in the declines in 2022. Leverage enables an investor to multiply the potential return on an investment. It can involve using borrowed money to amplify bets or other means to allow an investor to have exposure to an asset without fully owning it. Leverage amplifies movement in both directions, which can cause havoc in markets when things move to the downside.

History doesn’t always repeat itself; sometimes it rhymes. I started looking into the past to understand the present. Specifically, periods when interest rates were increased and financial markets experienced high volatility. I’m still early into this, but I’m looking into the mid 1990s now. It was a period of rate hikes and bond volatility that the Fed couldn’t explain at the time. Rate increases kicked off a sequence of events. We now know that volatility was caused by excessive leverage that most were unaware of at the time. Because the leverage wasn’t public knowledge, the volatility was hard to understand or explain. It’s early, and I still have more reading to do about other periods that fit my criteria, but what I’ve learned so far has been interesting.

I’m no economist, but my gut tells me we have more leverage in financial markets than we’re aware of. It may be amplifying market movements to the downside now.