Macro Minute: Week of February 24, 2025
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
Archimedes
Today I want to talk about leverage. Leverage is the reason we have a lot of the volatile market moves these days. My favorite thought around this is the quote from Warren Buffet about his late partner Charlie Munger. Charlie was fond of talking about the 3 L’s and how a person can go broke. This is Warren’s comment: “My partner Charlie says there are only three ways a smart person can go broke: Liquor, ladies and leverage. Well, the truth is – he only added the first two because they start with L – it’s leverage.” In other words, we may have our vices that cost us, but it is leverage that will break you financially.
We all live with a certain amount of leverage in our modern society. We all have credit cards, student loans, car loans, and home mortgages. These have become necessities to many people this day in age. We all know how interest rates have a large impact on the people’s ability to use these forms of leverage. Just a few years ago, people were able to take out mortgages at sub 3%. At that rate, the market was basically begging us to add more leverage. Today at 7% mortgages, you have to be much more judicious with home purchases. Regardless of the type of leverage a person uses, it can be financially fatal if not entered into with caution.
Now I would like to talk a bit about how leverage can get built into the financial markets. There are so many different forms leverage can take in financial markets. I will not be exhaustive in this piece to all the different forms, but I will give a few examples and historical market movements that have happened. In markets, one of the most dangerous things is success. If something works and is successful, then someone will naturally borrow money to make the bet bigger. For example, the success of some of the tech companies of the last few years, like Nvidia, have led to people levering up those positions. Nvidia has generated spectacular returns, but for some people they think “that is great, but what if we doubled the return (or loss) through leverage?” As a result, the ETF, NVDL, was created. Through options, the ETF looks to double the exposure to the Nvidia stock price. This causes extra volatility in the stock, meaning it exaggerates the movements.
Another popular strategy is to use currency valuations to add extra juice to your trades. An example of this was the Yen carry trade that added volatility last year. This could work by trading U.S. dollars for Japanese Yen, then buying U.S. tech stocks. If the Dollar strengthens relative to the Yen, you get boosted returns. Last year when the Yen reversed its trend and strengthened unexpectedly versus the Dollar, it caused a huge spike in volatility when the people involved with this trade had to sell U.S. assets.
One example of leverage that some people don’t consider is the leverage that is on corporate balance sheets. For example, some companies will have a lot more debt on the balance sheet. They will have loans that were taken for possible plant improvements or to fund mergers and acquisitions. If these companies’ investments are successful, the leverage will be worked down over time. If for any reason these investments don’t work out, then the companies will be more vulnerable and could even go bankrupt.
One other example of leverage that is very common is spread trades. These are usually expressed in the form of either steepening or flattening the yield curve. People will sometimes think that over a certain period of time that the yield on the long bond will either increase relative to the short end (steepen), or decrease relative to the short end (flatten or even invert). The way someone would be put on a flattening trade would be to buy the short end and sell the long end, (an example would be to buy 3-month treasuries and short 30-year treasuries). If you wanted to place a steepening trade you would buy the long end and short the front end, (buy 3-month and sell 30-year).
I am only touching on a few examples of leverage that is used by people and companies. The lesson here is to not take on more leverage than can be paid off. You may remember from some of my past writings, the object of investing is to compound returns for as long as possible. This means starting early and not taking on too much leverage that impairs your ability to continue compounding returns. The goal here is to not always have the highest return (leverage can amplify returns for a moment), but to be making returns for the longest amount of time possible.
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