What’s the One Thing That Never Changes?

Last week I talked about how the implosion of the short volatility trade was likely not the start of a bear market.

However, it is a nasty reminder that stock prices do, in fact, actually go down from time to time. I think that the record lull in market volatility is over for the foreseeable future. Expect big moves in both directions as speculators react to day-to-day events.

A bear market likely needs a nudge from a major default, a bankruptcy, or a painful increase in interest rates. As far as rates go, market pundits watch every move of the Federal Reserve to try and glean what the members might be thinking about inflation and the impact it will have on the markets.

I think those pundits are looking in the wrong direction.

They should be watching the London Interbank Offered Rate, or LIBOR for short. It’s an important rate because a lot of financial instruments – as is the case with the federal funds rate – are priced off of it.

LIBOR has been rising, so much so that the chart looks a bit like bitcoin. This could be a bad omen. Worse yet, the Fed is well behind the curve.

So what’s the problem?

Well, people with heavily invested portfolios at big banks have used ultra-low interest rates to borrow against their investment holdings to fund other needs. These lines of credit can be used for virtually anything. They may have used the money to pay for day-to-day expenses. Maybe they bought a boat or built a wine cellar. It’s easy money, and it’s cheap – rather, it has been cheap, until recently.

Sound too good to be true? I’ve used one myself.

It was surprisingly easy to access capital.

I have an elderly parent with health issues that I needed to relocate for both better medical care and closer proximity to immediate family. I borrowed against my portfolio and had access to the capital almost immediately. As long as I didn’t use the money to buy stocks, I was free to tap into the line of credit as I needed. Road trip to Austin, Texas, this weekend? Hey, no problem! Want to fire up a private jet to Cabo San Lucas from Dallas? We got you covered.

I used the line of credit for what I would consider a reasonable and fair situation. Rather than get a mortgage on a second home to take care of my parent, I just use the line of credit. It was cheaper and easier, and you’re essentially offering cash for a property which gives the buyer a lot of leverage in the negotiation.

What’s more is that I paid it back in 10 months, and therein lies the rub.

People may be using these lines of credit for all sorts of reasons, with little ability to pay them back if something causes stock prices to fall. Higher interest rates create a cash flow pinch, and falling stock prices create margin calls.

What are you supposed to do in that situation? As a sailing friend of mine once told me, “You can always buy a boat, you just can’t always sell one.” The heavy use of cheap money against stock portfolios will eventually blow up in people’s faces. Markets change, the key drivers of the markets change, but human nature never changes.

In 2015, when I first started researching credit lines, the three-month LIBOR was about 25 basis points. See, the rate fluctuates, and you have to tack on the extra percentage the bank takes as well. A loan that was about 0.85% a couple of years ago is nearly 3% today.

There’s a tipping point which could lead to a massive margin call on stocks when a snafu in the market occurs and these lines are shut down. What that point is, I do not know.

All I know is that we’re getting closer by the day.

Good investing,

This post was originally published on Economy & Markets and can be seen here.