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Margin Call

Updated: Jul 20, 2023

Last week, signs emerged that panic selling in many asset classes might soon spill over into stocks. The S&P 500 hit its lowest level since November 2020 last week before bouncing on Monday, and while that selloff was uncomfortable, it was relatively orderly and far from panicked.

It didn’t seem like a great way to end September, but September is practically always terrible anyway. On the other hand, the S&P in October is up 60% of the time with an average gain of 1% over the last 70 years. Better yet, if the S&P is down 15%+ year to date through Q3 (like this year), October is up 83% of the time with an average gain of 3%.

So, this week’s bounce may continue, but we still see that as a bounce within a bear market.


At this point, I think we’d all like to see a pause in rate hikes from the Fed in order to allow the economy to assimilate to the extreme tightening already implemented. We feel that a failure to pause will raise the risk of credit market dysfunction, which would be difficult to contain and fix-- as we just saw in the United Kingdom last week when the Bank of England pivoted and returned to quantitative easing.

When interest rates fall to zero, bond holdings in pension funds don’t generate as much interest income, yet pensions still need to pay benefits. So, in order to boost their incomes, pension funds borrow money at low interest rates to buy new long-term bonds using existing bonds as collateral. They essentially make up for lower yields by holding more bonds.

But when interest rates rise, the value of bond portfolios collapse at the same time the interest expense on their debt rises. These UK pension funds that had borrowed to buy long-term bonds got crushed because the value of the bonds they owned collapsed just as the cost of servicing the debt soared, and they were in a position where they were going to get margin calls to such an extent that they would have crashed the entire bond market.

So, in order to stabilize bond prices, the Bank of England stepped in to buy long-term bonds, creating artificial demand and propping up prices. We’ve been watching for signs of central banks pivoting away from their rate hiking, but this isn’t really how you wanted to see it happen-- a bond market collapse isn’t bullish.

Of course, now they have to print British pounds to buy these bonds, and we all know what that means. Instead of fighting inflation, which yesterday was public enemy number one and had to be stopped at any cost, all of a sudden, now they have seen the cost, and well, screw it-- let’s just create inflation.


What are the odds that the Federal Reserve will make a different choice than the Bank of England when confronted with the same situation? Because-- let’s face it-- the same thing could very easily happen here. We have a bigger debt bubble than the British and an even more grotesque inversion of the yield curve.

The U.S. Treasury market, while considered the deepest and most liquid in the world, has proved vulnerable to serious disruptions in recent years, epitomized by the turmoil in March 2020 when intense selling pressure overwhelmed securities dealers’ balance sheets, causing volatility to spike, spreads to gape, and liquidity to evaporate. According to PIMCO portfolio manager Tim Crowley, at times it was easier to sell investment grade corporate bonds than older “off-the-run” Treasury bonds.

Suffice it to say that a collapse of the US Treasury market is not our base case, but in the event of any sort of breakdown, we’d expect Fed intervention that would be concentrated at the long end of the curve just like the Bank of England’s. We would view a Fed that is compelled to support the back end via asset purchases (QE) as likely to seek to offset it with front end sales or runoff (QT), which would just mean you’d have to hold those two-years you bought last week until maturity.

As mentioned previously, though, October is historically a good month for stocks, and the market has viewed the Bank of England’s move as a sign that we’re closer to our own Fed pivoting sooner than previously expected. In this environment, we encourage investors to stick to your savings plan, to continue to count on your stocks being worth more in ten years, and to cuddle up on your couch with a bucket of popcorn while enjoying the greatest movie ever, Margin Call, for the 100th time.

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