The stock market plunged sharply this week, and I’m here to explain why we might be on the brink of a massive deleveraging event, triggered after a period of eerily low realized volatility. Adding fuel to the fire, margin levels have skyrocketed over the past month, even as reserve balances have plummeted. Investors seem to be turning desperately to the overnight repo market to amplify their leverage—a precarious move as funding costs have surged.

Let’s start with the obvious: the S&P 500 dropped about 2% this week after a sharp 3% decline, following the Fed’s hawkish pivot. This was followed by a brief rebound on Friday to the 61.8% retracement level, where it failed. Over the next few weeks, we’ll need to monitor how this plays out. Clear shifts have already occurred in the market, with early warning signs appearing at the start of December. For instance, the VVIX, which measures the implied volatility of the VIX, began climbing after the jobs report and continued through the FOMC meeting.

In early December, realized volatility levels were exceptionally low. Ten-day realized volatility was around 5% on December 3, while 20-day realized volatility stood at 6% on December 13. Using the rule of 16 (the square root of 252), this implies daily S&P 500 moves of only 31 to 40 basis points before realized volatility increases. With key events like the jobs report, CPI report, Fed meeting, and Bank of Japan meeting on the calendar, it became clear that implied volatility would rise—and the VVIX reflected this anticipation.

This could signal broader issues ahead. If we’ve entered a period of heightened volatility, historical parallels suggest it could persist. For example, we saw a similar spike in July, which led to elevated volatility through November due to the election. Last spring, a similar pattern emerged, with volatility rising rapidly before stabilizing by mid-May.

One of the biggest challenges now is the sharp decline in reserve balances held at the Fed throughout the year. Last year, rising reserve balances helped inject liquidity into the market, but this year, we’ve seen a reversal. This is tied to quantitative tightening, the drawdown of the Bank Term Funding Facility, and the normalization of the Treasury General Account. Compounding this, the reverse repo facility recently hit its lowest level in years.

Despite declining reserve balances, margin levels jumped 9% in November alone, an unusual increase given the liquidity backdrop. This suggests investors are sourcing liquidity elsewhere, possibly by leveraging collateral in the form of stocks through the repo market. This activity has pushed total securities outstanding to a new high, indicating investors are extracting cash for further leverage. However, financing costs have soared, as shown by the DTIC S&P 500 total return futures, which measure leverage costs. These costs have surged since mid-September, hitting record highs.

The rise in financing costs, coupled with increased dealer activity in the repo market, underscores the strain on dealer balance sheets. Investors are scrambling for leverage as costs climb, and while there was some relief late in the week, the futures curve suggests this strain won’t ease soon. Historical comparisons with 2021-2023 highlight how much cheaper financing was in prior years, further emphasizing the current pressure.

Rising realized volatility and funding costs could deter additional leverage in a more uncertain market environment. If volatility remains elevated—signaled by moves of 1-2% daily—the VIX could stay in the 16-20 range for some time. Monitoring primary dealer reports, reserve balances, and BTIC S&P 500 futures will be crucial for understanding how leverage and market conditions evolve.

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