2023-03-09 07:03:58 ET
Summary
- The stock market remains too high, which is very problematic for the Fed's struggling inflation fight.
- A reduction in margin use, knocking a peg out of equity speculation, could help rebalance the markets and economy after the Fed's record easing effort to fight COVID.
- If the end result is sustainable economic growth in 2024, why not help stock prices lower during 2023 into a reverse wealth effect short term, deflating cost-of-living pressures?
One big problem the Federal Reserve has faced in its inflation fight is Wall Street refuses to mark down stock values in a material fashion. In fact, total equity market capitalization continues to remain stubbornly high vs. GDP output. I have mentioned for months, high and rising stock prices only inflame wealth effects, pump economic demand, and support inflation running throughout the economic system.
YCharts - Total U.S. Market Capitalization to GDP Output, Since 1971
I even wrote an article in January here explaining how the Fed is caught in a rotten Catch-22 loop, where it basically cannot lower interest rates until the stock market declines significantly. If they attempted to drop rates now, the stock market would spike higher, as would the inflation rate. The institution would lose credibility all over the world, hurt the dollar’s value, and risk another jump to 8%+ YoY CPI as 40% of all products sold in America have some sort of export/import component.
So, if you want lower interest rates for mortgages, credit cards, car loans, etc., first we need another sizable stock market drop in price. The problem is targeting lower equity prices through higher interest rates will now have a brutal effect on the overall economy. Why is the Fed punishing hard working Americans at the bottom of the food chain with excessive inflation and interest rate policies, while we patiently wait for asset prices (including real estate) to deflate? There has to be a better way to get the desired result.
History of Margin Requirements
I propose the Fed use a different tool in its policy box: increase initial margin requirements from 50% and maintenance level minimums from 25%. Currently, investors can buy twice the amount of their brokerage equity with a margin account. You can borrow up to 50% of a purchase. For example, a $10,000 cash deposit can buy $20,000 in many Wall Street securities. Then, if your account value declines in market trading, a maintenance or margin call may occur when equity as a percentage of brokerage account worth declines past a set threshold of 25% to 40% (depending on your financial institution's risk-taking appetite). Margin calls force investors to either sell assets or deposit new cash/shares to pull equity above the maintenance level.
Margin equity percentage rates are set by Regulation T , authorized by the Securities Exchange Act of 1934 , and managed by the Fed.
In the early days of the U.S. stock market, big banks and brokerages required as little as 10% for money down by investors, loaning the other 90%. Out-of-control loan-fueled speculation helped create both the Roaring Twenties market boom and eventual 1929 crash of 50% in price over 12 weeks flat, along with the total wipeout bust of 85% in Wall Street value into March 1933. Without margin debt on stocks, the 1930s Great Depression may have been completely averted or turned into a normal recession. (Of course, a collapse in international trade with protectionist policies pursued by a variety of nations, and U.S. bank failures destroying base money stock, without FDIC insurance on deposits, were also culprits.)
Banks and brokerages did recognize froth in the market by late 1928 and began raising margin downpayments to 40% and higher into early 1929 (before Fed-mandated requirements became law). Rising interest rates engineered by the Fed and higher margin requirements both pressured the economy and markets into a tailspin by late summer of that year.
In the year 2000, at the end of the 1990s Dotcom Tech Boom , with stocks at modern-record valuations vs. GDP output at the time, the San Francisco Federal Reserve (Simon Kwan as author) posed the question in a research paper: should margin requirements be raised to slow speculation in the stock market? The author’s anticlimactic conclusion was modern markets can essentially find ways around simple margin requirement changes through options, futures, derivatives, etc.
However, I strongly disagree. I believe the stock market would be shocked into submission, on direct orders from the Fed that equity quotes needed to turn lower. It would up the ante on the mantra, "Don't Fight the Fed!" There have been a total of 23 margin requirement changes by the Fed over the years, with the last in 1974, generating the current legal structure for loans against equities. Unfortunately, the threat of margin requirement raises has been written off by most every financial expert as a relic of the past. Why not resurrect this tool and put it to proper use?
Margin Requirements as a Policy Tool? - San Francisco Fed (frbsf.org) - Initial Margin Level 1934-2000
Margin Debt Fluctuations
A brief history lesson of margin debt in modern times is in order. There are a variety of ways to analyze total margin debt employed by traders, investors and financial institutions vs. the markets and economy.
Of course, high rates of inflation well beyond 2% annually over the last 60 years (since leaving a gold standard convertibility for dollars) make it hard to compare different periods throughout our history.
Maybe the easiest way to restate margin debt is to inflate past values using the CPI construct. Inflation-adjusted numbers do not properly weigh long-term economic growth, but do give some context on the ever-increasing use of margin debt in the modern economy. Below is a chart back to 1970 of “real” levels of margin debt. The current level is about the same as 2013, although far greater than used in the 1970s. The good news is we are already far off the 2021 peak use of brokerage leverage.
U.S. Margin Debt Adjusted to CPI Inflation, Since 1970 - currentmarketvaluation.com
We can also review margin debt relative to overall stock market value in totality. Since both have risen with inflation over time, we are basically adding in the idea of long-term economic growth as an adjustment. This number peaked in 2008 just under 3%. Today’s 1.6% is dramatically lower and not much different than 1997. We are close to the 50-year average of 1.5%.
U.S. Margin Debt vs. Total Stock Market Value, Since 1970 - currentmarketvaluation.com
My favorite relative view is through a lens of stock market trading leverage paired against national economic output. By far the highest ever margin debt to GDP setup (and riskiest for future economic growth) was reached in 1929 at an incredible level of 12% !
Near the market’s zenith price during late 2021’s Big Tech 2.0 and Meme stock bubble, total margin debt to GDP achieved a new “modern” record approaching 4%, slightly above 2000’s 3% total or 2008’s similar 3% reading. Total margin debt of $920 billion (not inflation adjusted) was TRIPLE the $300 billion witnessed in 2000, and 12x the $75 billion in 1987 before that fateful autumn price crash of -40% over 10 weeks.
If there’s any good news on this margin debt front, today’s 2.3% to GDP reading is somewhat average vs. the last 20 years (but somewhat higher than the 60-year average of 1.5%). Systematic risks vs. decades ago are still high today, but not dramatically so.
YCharts - Wall Street Margin Debt vs. U.S. GDP Output, Since 2011
Final Thoughts
Then Fed Chairman Alan Greenspan’s famous “irrational exuberance” speech on December 5th, 1996 did little to slow the bubble building in the U.S. stock market during the late 1990s. While interest rates were nudged higher, margin loan requirements were not touched. To me, the Fed could have aggressively popped this speculative mania by dramatically raising interest rates on the economy and also increasing margin requirements. Both would have been real-world actions to jolt budding investor optimism, translating into markedly less profitable trading performance for those using leverage, while cooling economic demand for goods and services. If the Fed’s true goal was economic stability, this decision was a no-brainer (and I said as much during that period).
Why can the Fed engage in “unlimited QE" money printing to fight a pandemic and crushing economic shutdown, while an opposite and aggressive tightening is off the table? Maybe the opposite needs to be equally considered when inflation rates are painfully high and the stock market refuses to come back down from a record overvaluation plateau. To regain some shred of credibility that a normalized “balance” is desired in the U.S. economy, you have to be aggressive on both sides of the easing/tightening bank policy coin.
My suggestion is the Fed can refrain from future large interest rate hikes in favor of more directly attacking excessive investor confidence and wealth, the core of inflationary demand pressures in 2023. I propose moving margin requirements higher by 10% each, to 60% on initial purchases and 35% for a minimum maintenance number. A loud gesture by the central bank aimed at telling brokerage lenders and borrowers the stock market is too high would have an immediate and profound impact on confidence and future speculation, in my opinion. It would also mechanically require the selling of hundreds of billions of dollars in equities, or subtract a similar number out of cash, savings, bonds, and hard assets, which would effectively tighten liquidity conditions further in the real economy.
If equities decline another 20%+ into the middle or end of 2023, inflation rates will likely fall back closer to 2% YoY targets, and the Fed can work its way into an easing monetary stance. Lower interest rates, renewed credibility in the financial system, and a smarter balance between the economic forces of buyers/sellers, demand vs. supply, borrowers and lenders of all types would be the best outcome for all of us. We might even get honest economic growth in 2024 for the first time since 2006 (like existed before the Great Recession credit bust and nutty QE Fed experiment, U.S. bond market interference began in late 2008). I want to believe the future is bright. The Fed needs to do its part to make such reality.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
For further details see:
The Fed Wants Lower Stock Prices: Consider Raising Margin Requirements