The problem is that leverage cannot be measured by a single clean dashboard.
Takeaway
• Leverage is rising across margin accounts, leveraged ETFs, hedge-fund structures and the shadow-banking complex, even if the market has not yet been forced to acknowledge it.
• The Fed’s reserve-management purchases are not just an operational footnote. They are increasingly the liquidity backstop beneath a market that has become accustomed to financing risk at scale.
• Kevin Warsh may want a leaner Fed balance sheet, but shrinking the liquidity cushion becomes far harder when investors are still swimming through markets on borrowed floaties.
• The dollar’s comeback reflects widening US rate support, but a stronger dollar also tightens the screws on the very global leverage structures that have helped keep risk assets airborne.
Dancing on Borrowed Liquidity
Over the weekend, and again in this morning’s paywalled notes, you may have wondered why I, along with a growing chorus of Wall Street traders, strategists, and market delta-one quants, keep hammering the leverage theme. It is not on the front page. It is not even getting much space below the fold. Markets are too busy celebrating AI, IPOs, record equity prices and the apparent return of the to spend much time worrying about the machinery underneath the floorboards. But that is exactly where the next real accident is most likely to begin.
The market is partying like leverage is somebody else’s problem. Equities are sitting near the penthouse, volatility is still being treated like cheap insurance, and every fresh high gives investors another reason to borrow against tomorrow’s gains. Yet beneath the champagne floor, the building is carrying more debt, more synthetic exposure and more hidden dependency on liquidity than the price action is prepared to admit. The risk is not that leverage exists. Leverage always exists. The risk is that it becomes invisible during the rally, only to become the only thing anyone can see once prices begin to slip.
That is why the Fed’s reserve-management purchases matter. On paper, they are simply a way of keeping enough reserves in the financial system so that markets function smoothly. In practice, they are the Fed topping up the waterline beneath an increasingly leveraged ecosystem. The more uncomfortable interpretation is that these purchases are not merely routine maintenance. They may be helping to prevent the first domino from wobbling.
When a system becomes accustomed to abundant liquidity, the absence of cash is never just an inconvenience. It becomes a funding squeeze, then a collateral scramble, then a race to sell whatever can still be sold. That is the ugly logic of leveraged markets. Nobody worries about funding when asset prices are rising, and collateral values are expanding. But once the market reverses, the leverage that magnified gains starts magnifying every crack in the foundation.
This is the dangerous phase of the cycle: when the market stops pricing risk and starts renting it. Record highs become collateral, calm volatility becomes permission and every successful dip-buy teaches investors that downside is merely a temporary inconvenience outsourced to the Fed, dealers or some unnamed liquidity provider. By the time leverage is visible in the headlines, it is usually no longer the fuel for the rally. It is the accelerant beneath the floor.
The problem is that leverage cannot be measured by a single clean dashboard. We never know exactly who owes what to whom, or which pockets of the financial system are most vulnerable, until a weakening economy or falling asset prices pulls the curtain back. But the fragments we can see are enough to make the market strategist in me uneasy.
Leveraged ETFs tied to the and the have become increasingly popular this year. That matters because these products are not merely passive expressions of bullish enthusiasm. They are accelerants. In a rising market, they turn momentum into more momentum. In a falling market, they can force hedging flows that turn a routine decline into something more mechanical and more violent. They are the financial equivalent of strapping a turbocharger onto a car that is already speeding toward a blind corner.
Then there is margin debt. Borrowing in investor securities accounts has climbed to around $1.4 trillion, an all-time high. More telling still is the pace of growth. Margin debt expanded at more than 50% year-on-year in April and May, a rate that begins to rhyme with the post-COVID liquidity binge, the 2007 cycle and the late-1990s technology bubble. Margin debt is never the story during the ascent. It becomes the story only after the market has already started falling and yesterday’s confident investor wakes up as tomorrow morning’s forced seller. (prime broker data)
Hedge-fund borrowing is also running toward the upper end of its normal range. That tells us the professional risk-taking community is still leaning into the market rather than stepping away from it. Yet the picture is not uniformly flashing red. Repo volumes, the secured overnight funding that helps finance securities and derivatives trades, peaked in January, rolled over modestly and have remained broadly stable for several months. Repo rates have also stayed calm.
That may indicate that the Treasury basis trade, one of the great consumers of leverage and balance-sheet capacity in recent years, has become less popular. Hedge funds appear to have reduced some Treasury futures shorts, which suggests they have trimmed the cash-futures basis trade that historically drove a significant portion of repo demand. But this is the part of the story markets must not get complacent about. Leverage rarely disappears. It simply changes costume. Some of that exposure may have migrated into swap-spread trades or other relative-value structures, where the risk is less obvious but no less real.
The more interesting warning light may sit in the shadow-banking complex. US bank loans to non-depository financial institutions, including mortgage lenders, private-equity funds, private-credit funds and other non-bank lenders, rose 30% in the first quarter from a year earlier. These loans now account for 12% of total bank lending, up from 10% only a year ago. That is not a small technical shift. It means the link between the regulated banking system and the less transparent pools of private finance is widening at the same time as asset prices are elevated and investors remain hungry for return.
This is where Kevin Warsh becomes the market’s most underappreciated variable. Warsh has never been a natural supporter of oversized central-bank balance sheets or of the market’s growing dependence on permanent liquidity abundance. The Fed remains committed to an ample-reserves regime for now, but that could look very different by year-end. Warsh may want to drain the pool. The problem is that a large part of the market is still swimming with borrowed floaties.
That is the tension investors are not yet pricing properly. It is easy to talk about a slimmer Fed balance sheet when markets are calm, collateral is rising and funding is plentiful. It is much harder to reduce the liquidity cushion when margin debt is surging, leveraged ETFs are growing, hedge-fund borrowing is elevated, and shadow-bank lending is expanding. The Fed may want to remove the punch bowl, but the market has spent years building a larger and more leveraged party around it.
And this is why the political dimension matters. Hartnett’s warning that a Republican loss of the Senate in November could trigger a sharp reset across the familiar policy-sensitive trades should not be dismissed as merely a Washington talking point. In that scenario, the market could be looking at a weaker dollar, lower Treasury yields and softer equities all at once. More broadly, it reinforces one of the oldest rules in markets: booms and bubbles rarely die of old age. They tend to be ended by voters, bond vigilantes or a volatility shock that exposes just how crowded the trade has become.
The spark could come from anywhere. It could be a Senate surprise. It could be a yen surge or a won dislocation. It could be a Treasury market wobble, a failed peace deal, a disappointing growth number, or a sudden shift in central bank expectations. The trigger is almost beside the point. What matters is how much dry tinder is sitting in the room when somebody finally strikes the match.
The is part of this same story. The greenback has strengthened more than 2% since the Iran war began and has climbed to its highest level in roughly a year following last week’s Fed meeting. Bullish dollar bets in the futures market have also risen to their strongest level in close to a year. Some of that is geopolitical. But the deeper driver is the return of the old rate-differential logic.
The US economy has held up better than the market feared, labour-market panic has eased and the Fed’s latest message has pushed further out of sight while keeping the possibility of additional tightening alive. At the same time, much of the rest of the world is dealing with weaker growth and a fading energy shock that may leave central banks with more scope to remain accommodative or eventually ease. For foreign investors, the equation remains brutally simple. They may dislike US policy noise, but the risk-adjusted return on US assets is still difficult to ignore.
The old inverse relationship between the dollar and equities is also returning. That correlation broke down after the Liberation Day fiasco, when confidence in US policymaking weakened, and the dollar lost part of its defensive bid. Since the conflict with Iran, however, the relationship has turned negative again. When uncertainty rises, investors are once more reaching for dollar liquidity. The greenback has resumed its role as the cleanest dirty shirt in the global wardrobe.
The may still have room to run. With the premium over other major developed markets widening again, the dollar could plausibly move from around 100 toward 102. But that is where the leverage story and the dollar story merge. A stronger dollar is not just a vote of confidence in the United States. It is also a tightening mechanism for the rest of the world.
Every additional move higher in the dollar puts more pressure on global balance sheets, emerging-market funding structures, dollar-funded trades and international investors who have spent years relying on abundant liquidity and contained currency volatility. The stronger the dollar gets, the less it feels like a tailwind and more like a vice tightening around global risk appetite.
That does not mean the market is on the edge of crisis today. Repo markets are calm. Asset prices remain elevated. Liquidity is still plentiful. But the market is carrying a familiar combination of ingredients: high valuations, fast-rising margin debt, expanding shadow-bank exposure, increasingly popular leveraged products and a central bank that may eventually want to reduce the excess liquidity that has helped keep the whole structure stable.
The next VaR shock does not need a grand narrative. It only needs one moment for the market to discover that the liquidity it assumed would always be there has become more selective, more expensive, or simply unavailable.
That is when leverage stops being an invisible tailwind and becomes the trapdoor beneath the rally.