Divergence of financing rates

Divergence

In markets, when we look for financing rates, we should always observe, as any first‑year textbook teaches you, the Treasury Bill rates. And this applies to both long‑ and short‑term financing.

Short‑term interest rates, those of the money market, are also often influenced by the reserve management of large institutions. By managing their liquidity day to day efficiently, they move prices, which is reflected in the rate.

A good example is the SOFR rates (a type of asset repurchase rate), which can move closer to or further from the policy rate. When the short rate approaches the Treasury rate, that is good news. In fact, alignment with the sovereign rate has been a pattern in money‑market financing.

That said, if we look at another short rate — the rate to finance short‑term equity purchases — the rate has moved away from the policy rate. The leverage rate for equity trades has continued to rise throughout the cycle. This rate tells us there is an imbalance between demand for equity exposure, on the one hand, and the supply of capital available from intermediaries to finance those positions, on the other. Therefore, this operation is becoming more expensive.

Demand for equities has been very strong, but not so for other operations, such as in the money market. In other words, banks are willing to lend in one market but not in another. One is cheaper than the other. The first point here is that, as the short‑term equity‑lending rate rises, intermediaries are pricing in the risk of a bullish but fragile market (volatility). Second, as we know, the regulatory element is important, because lending in the equity market, for a bank, entails higher capital requirements than those demanded in the money market. Third, in legal and financial terms it is difficult to move capital on the balance sheet from fixed income to equities, because (i) the measure of risk‑weighted assets changes, as does the liquidity coverage ratio (equities do not qualify as liquid assets) and the Volcker Rule; and (ii) it unbalances asset‑liability management — equities introduce volatility (it is a shift from Hold to Maturity to Mark to Market) and VaR forces a reduction in return on equity (ROE).

That said, the market adapts. Balance sheets can be adjusted toward longer maturities to increase availability in the more costly markets. The problem, then, is maturities.

Deleveraging

Scarcity, not abundance, pushes prices higher. Prohibitive prices cannot sustain the rally. As a result, the risk of deleveraging increases. Rising interest rates in the money market, low capital liquidity, and high financing costs typically trigger deleveraging.

This phenomenon is the reduction of a position because it lacks capital backing or because it breaches regulatory limits. Leverage must be compatible with capital and regulation. Expansion or contraction of bank balance sheets is the manifestation of (de)leverage. It is the first symptom.

Deleveraging risk leads to losses that arise from a sudden, widespread reduction of investment positions in a specific asset. It is a market mechanism. During periods of extreme volatility and reduced access to financing capital, leveraged investors are forced or choose to reduce their risk exposure. This causes panic selling of long positions, or frantic buying when investors need to close out short positions.

Because it is not possible to observe directly which assets leveraged investors hold, short selling is often used as a proxy, relying on daily stock‑loan data. Although stocks with heavy short interest normally have lower future returns, during market shocks and funding shortages the most shorted stocks often experience strong positive returns. This happens because of the aggregate pressure from short sellers scrambling to buy shares to cover their positions.

AI Risk

The risk in this context is that the market deepens its concerns about debt. As we know, investing in AI infrastructure was comfortable for investors when it was financed with company earnings. By contrast, when hyperscalers turned to debt financing, the market was not entirely comfortable. It is clear that mega‑caps view this spending as existential, an inelastic demand to meet their objectives. But investors can change their minds and redirect capital to other assets. Investors do not have an inelastic supply of capital.