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The Fed has a simple tool it can deploy to curb speculation in the markets

The Marriner S. Eccles Federal Reserve Building is located in Washington, DC, United States on Tuesday, August 18, 2020.

Erin Scott | Bloomberg via Getty Images

Many indicators of market euphoria are flashing red as the market heads to new, unexplored highs.

There are many tools in the financial toolkit to assess stock market euphoria, and here’s one that’s as scary as anything.

The chart below measures margin debt as a percentage of GDP.

As of December 30, 2020, margin debt in the United States stood at $ 778 billion, which is 34% more than the amount of $ 679 million a year earlier.

Measured as a percentage, margin debt now stands at 3.6% of GDP, a figure that can be added to the list of frightening statistics of the current market exuberance.

Note that we have now passed the peaks of 2000 and 2008 in terms of margin debt as a percentage of GDP. These two periods were followed by major declines in the stock markets.

Given today’s comparable state of euphoria, it seems odd that the Federal Reserve is not using one of its tools that could alleviate excessive market speculation.

The Fed has the power to regulate brokerage margin rates under Regulation T, but it has not used this power since 1974, when the margin rate for borrowing on stock purchases was set at 50% .

With a 50% margin rate, investors can borrow up to 50% of the amount of their qualifying stock purchases. This means that an investor who wants to buy $ 10,000 of stock can buy for $ 20,000 by simply putting in $ 10,000 and borrowing the rest.

It’s easy to see how this kind of purchasing power can give momentum to a speculative bull market.

In 1929, there was no Federal Reserve, but brokers loaned speculators up to 90% of the value of their stock purchases, fueling the fire of soaring stock prices.

As we all know, this was followed by the crash of 1929 and the onset of the Great Depression.

As the chart below shows, prior to 1974 the Fed paid a lot of attention to markup rates and changed the rate many times considering market conditions and other factors at the time.

T settlement initial margin requirement

Yet, as we have pointed out, the Fed stopped using this tool in 1974. It might be a good time to review this policy.

—Peter J. Tanous is President of Lynx Investment Advisory in Washington, DC.

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