The big surges in margin debt in both 2000 and 2007 point out some similarities between the two periods, but there are also some big differences. For one thing, notice the difference in volatility, as demonstrated by the roughness of the chart before 2003 and the smoothness after 2003




Volatility has been squeezed out of the market both via computer trading and the derivatives markets. Hedge funds and trading desks at the major banks have taken the risky side of volatility bets in order to ensure a high probability of a small return. I personally believe that some of the largest players are involved in selling large amounts puts and calls and then using computer trading models to help ensure that volatility remains contained so that their derivative bets remain highly profitable.

As the trend in declining volatility has increased, more and more traders have joined into that game, further compacting volatility, but also increasing the risk of the risky side. The hedge fund compensation model equates to "heads we both win, tails you lose" so highly risky bets are right up the ally of many fund managers.

Last week's decline was not big by 2000 standards, but it was the largest weekly decline in 4 years. Because it was so unusual, it was probably large enough to put a crunch on some overexposed funds. Some large hedge funds blew up last year when energy prices moved against them. In that situation, it made sense for managers to double down with client money and hope for the best. In 2000, buying the dip was an entrenched philosophy for retail investors. In 2007, double-down and pray has become a philosophy for some hedge funds.

Margin debt in 2007 finally topped the 2000 totals, but even more hazardous to the health of the markets is the leveraged nature of hedge funds. Underlying much of the yield chasing bet is a highly leveraged bet against the Japanese Yen via the carry trade. Many traders have borrowed Yen and bought Dollars in order to take advantage of low Japanese rates. A big enough move up for the Yen, and/or a big enough move down in stocks or bonds will break through the resistance set by volatility traders and cause a forced unwinding of those trades. Right now, they are probably pushing back hard, but the weight of global imbalances will likely win out eventually. As I interpreted the charts, on Thursday and Friday the Yen rallied while the Western hemisphere slept, then retreated a little when Western traders got to work increasing the size of their bets.

I see the value of the Yen as my biggest indicator of who is winning out in this battle against the volatile nature of markets. If the Yen continues to rise, then I'll expect that the carry trade is being unwound and that leveraged players are being forced out of their positions. I'm also watching the actions of the Fed and other central banks, which so far are not showing any signs of panic. There was just one large permanent injection early last week of $1.8 billion, and custodial holdings only increased by $7.7 billion (high, but down from recent weeks). Meanwhile there wasn't much movement in the RMB/Dollar rate. I think that China has done a lot to force the unwinding by bringing the dollar down 6.7% against the RMB and they can choose to force things a lot faster if they like. I also think that Japan still wants to keep the Yen weak to protect their manufacturers if at all possible. The BoJ and the Fed still have plenty of ammunition to protect the carry trade if they want to use it.

In 2000, margin debt was forcibly unwound in the month leading up to April 15th (income tax day). Big capital gains tax bills met with a hugely over-saturated market for IPOs and rising short term interest rates to kill off the bull market. The Fed was glad to let overexposed retail investors take their losses. The markets stabilized through the summer, and it wasn't until September, when the technology sector started contracting due to a lack of new investment that the stock market really began their long, bear market. My hunch is that this decline will stabilize before long when the BoJ and Fed decide to get more active, but that the rapid credit expansion of the past 4 years has probably run its course. If that is the case, then corporate profits and the financial markets may begin retreating later in the year from their overextended positions.

When the real decline finally begins, it has the potential to be very sharp, because of the way volatility has been suppressed for so long. Along the way we may see the collapse of many hedge funds, some major defaults in the derivatives markets and a string of shocking bankruptcies and revelations from the financial sector.