Traders are afraid of the FOMC ProShares UltraShort Lehman 20+ Yr(ETF) (NYSEARCA:TBT)

Interest Rates are on the rise, iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT) has been falling and ProShares UltraShort Lehman 20+ Yr(ETF) (NYSEARCA:TBT) has been increasing, and traders do not like it.


But traders are no different than consumers, who are extremely fickle when it comes to buying goods and services, so this could be transitory right?  In fact traders are consumers too, so it's not a surprise that they can turn on a dime from the hand that has been feeding them. 

At the same time, this is business, so it adds to the nature of the problem. 

Traders were once embracing almost everything the FOMC had to say, because it was what they wanted to hear, but the moment the FOMC started to say something else, something that is not perceived to make them money, those fickle traders took issue.

They are, in fact, taking issue right now.  Traders do not want the FOMC to raise rates because it dampens economic activity, but there's much more to it that that too.  The first is margin debt interest, and then of course we know what tightening will do to the liquidity crisis that already exists too.

I'll address the margin debt issue here.  There is more margin debt on the books today than ever before, but what's worse there is less cash as a proportion to that margin debt too.  That means traders do not have much additional buying power (as a whole) and they need to service the debt they already carry.

This is where the problem comes in. 

Institutional traders, who largely influence the statistical measures of margin debt offered by the NYSE, often carry leverage that is 2, 5, or even 10 times the equity in their portfolios.  Because the cash-margin debt levels are still close to all time low, it's safe to say that the odds favor higher leverage ratios too, but that is not a readily available macro statistic, so we just need to make assumptions.


Assume a fund is leveraged 2x above their equity, so instead of $100 million in equities they hold $300 million.  Then assume their margin interest rate is 2%, which is a pretty generous assumption even in today's rate environment (more like 4%).  That fund would pay 2% on $200 million, which equates to a 4% performance offset to the $100 million of equity.   For the manager to realize performance fees he would need to make more than 4% plus whatever base fee is charged, usually 2%, so the hurdle is 6% in the above example.

However, let's assume that margin rates move up by 25 basis points, and then another 25 later on.  Upon the first hike that hurdle rate would increase to 6.5%, and then to 7%.  As it was, the 6% hurdle rate looked high, especially with slowing earnings growth, but suddenly a forward looking observation would raise even more concerns. 

If rates increase it's going to be harder for the funds to reach their hurdle rates, but what's more important is this is happening during a time of economic uncertainty, and at a time when earnings growth is expected to slow considerably.  I am not adding in my proprietary observations that a Liquidity Crisis exists (The Investment Rate), but that's important too.

Intelligent investors are going to see not only higher hurdle rates on a pure interest basis, but also greater challenges to growth not only in the current environment, but especially in an environment where the cost of money is increasing.  The decision of those investors is therefore in flux.

No wonder why traders are perceived as being fickle right now; their livelihood is on the line.

When it boils down to it, many of them don't think the higher hurdles rates in association with lower growth warrant the added leverage that they may already be holding.  The resulting decisions are often, in that case, to reduce exposure.