Last weekend in "The Most Convex Trade of My Career," I wrote: Once again, I planned to write a comprehensive note, but the oil section got long, so I'll write my thinking in two installments and get the second out soon on broader risk assets, positioning, and most importantly funding (very important, we need to come back to this).
It's time to address this. Rather than rehash the incredibly stretched sentiment and positioning of late (call buying, retail leveraged trading via margin lending and levered ETFs, Korea/semis, etc), I want to focus on equity funding.
Back in November I wrote "When Fast Markets & Tighter Funding Collide," citing my friend Kevin Muir's primer on equity funding.
Where are we today? Last week, heading into month-end, equity funding tightened almost as if we were having a quarter-end or year-end dealer balance-sheet window-dressing moment. That's weird for May — and why I paid lip service to funding last weekend — but I wanted to see if it would stick past month-end. After easing earlier this week, funding has exploded to new tights… and this is a problem.
What's more interesting: if this were a dealer balance-sheet capacity issue, you'd expect swap spreads to go much more negative… they haven't. We also haven't seen a big move in gross short positions from dealers in equity futures, so the rise in equity "inventory" is not because dealers are ramping up a stock-index- futures basis trade. Instead, the equity funding cost rise simply reflects a raw rise in demand for leverage from speculators. Last week I heard the Hynix 2x long ETF in HK was running out of swap capacity, and will now have to piece together its daily 2x return via a combination of equity and options (dealers will charge them through the teeth). The last time we saw this in a high-profile way was the MicroStrategy 2x leveraged ETFs after Trump's 2024 election — and we know what's happened to MSTR (and the levered ETFs) since then.
Many of you saw Goldman's comments about the explosion in levered ETFs in recent weeks. Conversations with prime-broker friends confirmed the HK-listed 2x Hynix ETF was already paying KIBOR +850 for swaps. Not a coincidence that last Friday saw the largest SPX call volume session of all time, with calls 70% of every option traded (per Goldman). Prime brokers were charging 3% or more for Hynix, Samsung, TSMC, and Kioxia longs — this does not normally happen (longs should get credits from prime brokers who rehypothecate your stock out).
Bottom line: speculation has vaulted completely off the page. We are right back in late 2024, going into less-liquid summer months (volumes yesterday were woeful), when hundreds of billions of equity supply is set to hit the market, requiring even more funding from grossed-up hedge funds to carry. A reader asked if the SPCX IPO and the recent buckling of hot issues like CBRS and QNT are indicative. Recall my primer from last September on "When IPOs Forewarn Market Rollovers." Yes — we're doing this again. For ECM books, it's "last in, first out" to make room, running headlong into funding constraints. It's always funding constraints that end the party. I think Momentum and Beta factors are in big trouble here, as are any gross exposures over their skis. Stay frosty…
— Paulo aka Cloudbear
================================================================ APPENDIX — Kevin Muir (The Macro Tourist), equity-funding primer
Banks charge customers (pensions, hedge funds, endowments) different rates to borrow, based not just on creditworthiness but the asset pledged as collateral — US 3-month T-bills fund far cheaper than MSTR convertible bonds. There's a general equity-funding rate many sell-side shops report daily; as demand for equity funding rose, its cost increased. Example: a pension wants S&P 500 exposure for a year but may face a capital call elsewhere, so it gains exposure via a swap — receiving the total return of the S&P 500 and paying a floating rate (SOFR or Effective Fed Funds). The bank buys and holds the stock, charging a fee (the bank has no market risk — it owes the return up, is made whole down). That fee is the "cost of funding equity positions"; as more clients ask, banks charge more (equity concentration risk). In Q4-2024 this funding cost more than tripled.
Important: funding tightness can be rising demand for leverage (very long equities) OR tightening dealer balance sheets (declining supply) — not always clear which. The CME now lists an Adjusted Interest Rate (AIR) Total Return future on US equity indices (Bloomberg ticker AXW) — a listed total-return swap quoted as a rate over EFF or SOFR, removing dividend/interest risk to leave just the cost of funding an index equity position (vs an index future, which is a forward embedding dividend + funding assumptions).