Wall Street's buying frenzy and surging demand for leverage may be brewing the next "volmageddon" in US stocks.

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Simon White, senior reporter and market strategist for Bloomberg's Market Live column, recently published a thought-provoking market commentary, revealing the hidden risks beneath the apparent prosperity of the current US stock market. He sharply pointed out that market participants are using leverage on an unprecedented scale in pursuit of higher returns.

What are the consequences of this feverish chasing behavior? Simply put, due to the surging demand for stock leverage, the market’s financing rates are under immense upward pressure. With the explosive demand for derivatives like Total Return Swaps (TRS), dealers' balance sheets have been stretched full.

White warns that the entire stock market is exposing itself to increasing vulnerability, especially as the risk of sudden spikes in individual stock correlations rises. It's like dancing on a powder keg—once sentiment reverses, the consequences would be unimaginable.

The core view of this article: Endless chasing sentiment and TRS-driven leverage demands have overloaded dealers’ balance sheets and pushed financing costs higher.

And such prosperity built on enormous leverage has potential consequences that cannot be ignored. If extremely low market correlation reverses, highly leveraged positions will face ruthless margin call notices. As investors enjoy the current feast, perhaps they should examine their own risk exposure, to avoid severe damage in the next possible “volatility apocalypse.”

Leverage Mania: Dealers’ Balance Sheets Under Strain

How exaggerated is the current demand for leverage? We can imagine Wall Street dealers as the “chip suppliers” in a casino. Now, gamblers are madly borrowing chips to win big in the rising market.

White notes, “We have seen explosive growth of bullish option positions in the options market, as traders are chasing upside potential.” This means vast sums are betting on continued market rises.

Moreover, the leverage exposures dealers provide to stocks via futures and TRS have reached record levels. Here White highlights a shocking finding: “Their stock inventory on balance sheets has risen to a high of $223 billion.”

Accompanying this massive inventory is stock financing rates soaring to near historical highs. Why does this happen? White explains it’s driven by strong demand, but dealers are also facing severe supply-side bottlenecks.

On one hand, they’re under strict regulatory constraints; on the other, they must reserve funds for potential large IPOs like SpaceX. It’s like an already crowded warehouse suddenly needing to fit several huge containers—naturally, it’s stretched thin and funding costs surge.

Tracing the Roots: Who's Raising Financing Rates?

With financing rates so high, who is borrowing crazily? Traditional fund managers or leveraged ETFs? Through careful data analysis, White ruled out some obvious “suspects.”

He observed that the net equity futures positions between asset management companies and levered funds are actually declining. To better understand this complex indicator: usually, asset managers (who are long-term buyers) have futures demand met by leveraged funds (usually short sellers).

If the former’s demand for futures is excessive, net positions should rise. But currently, data is declining, suggesting the futures market is not the main cause of drained liquidity. Additionally, inflows into leveraged equity ETFs are also decreasing.

Having ruled out futures and leveraged ETFs, the culprit becomes clear. White points directly to TRS demand. TRS, or Total Return Swap, is a financial contract allowing investors to enjoy the gains and losses of stocks with leverage, without actually purchasing the stock.

This hidden leveraging behavior, combined with IPO-related balance sheet constraints, has together pushed financing rates to new highs.

Hidden Dangers: Correlation Bottoming and the Shadow of “Volatility Apocalypse”

High leverage itself isn’t a death sentence—the danger is when it combines with extreme market structure. White gives a clear warning: As leverage balloons, “the market is becoming extremely susceptible to sudden increases in correlation.”

How to understand risks from individual stock “correlation”? It’s like a group of people skating on ice. If everyone skates their own path (low correlation), the pressure is spread out; but if everyone suddenly panics and runs in the same direction (correlation spikes), the ice collapses instantly.

Currently, stock index correlations continue falling to near record lows, meaning the risk balance is tilting toward “higher correlations.” White provides a chilling statistic:

“In at least the past 25 years, the average pairwise correlation among S&P 500 components is at its lowest, second only to the eve of 2018’s so-called ‘Volmageddon’.” That year, short volatility positions faced violent liquidation, triggering severe market tremors.

Of course, current market sentiment remains complex. White mentions, recent progress in US-Iran peace talks seems to have revived the market’s ‘animal spirits’. Regarding this sensitive geopolitical topic, views diverge: optimists think cooling geopolitics benefits risk assets, while cautious observers believe it can’t cover up underlying structural fragility.

While sentiment has warmed, White remains highly vigilant, referencing another expert’s opinion. He concludes: Bloomberg colleague Mark Cudmore previously predicted: risk-return remains poor. In other words, the revival of animal spirits doesn’t mean the odds for entering the market have greatly improved.

Risk Warning and DisclaimerThe market involves risk, and investment requires caution. This article does not constitute personal investment advice, nor does it consider the specific investment objectives, financial situation, or needs of any particular user. Users should consider whether any opinions, views, or conclusions in this article are suitable for their own situation. Investments made based on this are at your own risk. ```