Another day, another dour assessment of market liquidity.
Earlier this week, Goldman set out to quantify the extent to which adding “liquidity factors” (i.e., top-of-book depth, single stock liquidity and market volumes) to a model of forward 1M realized vol. increased predictive power. Unsurprisingly, the bank found that incorporating those factors “boosted the R-sqrd in 2018 from 5% to 45%.”
The takeaway: liquidity is an increasingly important factor when explaining volatility spikes, something that is so intuitive that it only bears mentioning because the vast majority of market participants still don’t generally grasp it and are thus left scratching their heads when selloffs turn into outright routs.
The problem here – and we’ve been over this dynamic on too many occasions to count – is that when circumstances conspire to trigger a risk-off move, modern market structure acts as dry kindling. So, taking the February rout for example, rapidly rising yields flipped the stock-bond correlation leading to acute pain for risk parity and balanced funds in the week ahead of the January jobs report which, when it hit, was accompanied by an above-consensus AHE print that stoked further inflation concerns. On Monday, February 5, that burgeoning angst collided with i) the buildup of rebalance risk in leveraged and inverse VIX products, ii) systematic selling, iii) option hedging effects and iv) evaporating electronic liquidity (i.e., an acute lack of market depth) to catalyze a crash.
We saw a similar series of events play out in and around the October 10 meltdown (minus the VIX ETP issue, of course), with analysts putting some of the blame for that day’s collapse on option hedging and CTAs.
Well, on Thursday, SocGen is out with their 2019 equity volatility outlook and in it, they hit a lot of these points in a section called “Assessing the impact of technicals on equity volatility.”
The bank breaks things down into two discussions: systematic flows and liquidity.
On the former, SocGen reminds you that “the simplest derivative overlay strategies involve selling a call for yield enhancement and buying a put for protection from drawdowns.” The bank goes on to describe the charts shown below, noting that “when dealer call-put gamma turns negative on aggregate, the market experiences higher volatility, and vice versa.”
Clearly (and SocGen acknowledges this), that’s a simplified assessment, but it does the trick.
The bank goes on to address something we and others (where “others” means a handful of sites which, while generally moronic, do a decent job covering these dynamics) have touched on repeatedly since October. To wit, from SocGen:
A fall below the 2800 level since mid-October has coincided with higher daily moves (and volatility) on the S&P 500. This also happens to be an area where dealers seem to carry negative gamma exposure, thereby potentially exacerbating moves, leading to higher volatility. This framework would suggest that the S&P 500 needs to escape this range (or enough options need to automatically expire) for volatility to settle down.
Again, that should sound familiar to regular readers.
Moving from systematic flows to liquidity, SocGen breaks things down in terms of “top-down” and “bottom-up.”
“Top-down” is especially important at a time when markets are hyper-sensitive to communications about central bank balance sheet rundown. As you’re hopefully aware, part of Wednesday’s rout on Wall Street was attributable to Jerome Powell’s steadfast refusal to alter his assessment of how balance sheet rundown is proceeding and whether the timing/pace needs to be tweaked.
“Since the taper tantrum, which perhaps was the first signal that liquidity would be steadily withdrawn going forward, the perception of equity risk has become closely aligned with the change in measures of money supply”, SocGen writes, before driving the point home by emphasizing that “as central bank balance sheet changes have become negative this year, volatility has also picked up in earnest.”
On the “bottom-up” point, the bank cites – you guessed it – deteriorating top-of-book depth and all of the other indicators mentioned by, among others, Goldman’s Rocky Fishman and JPMorgan’s Marko Kolanovic.
SocGen’s brief exposition on this is eloquently put, and although we could probably make it more colorful or otherwise inject some comedic value, we’re not entirely sure that’s necessary here, so we’ll just give you a couple of direct excerpts that spell out the bottom line. To wit, from the bank’s note:
Whether it is a structural or cyclical change, there is clear evidence that depth of order books has severely diminished this year, even on the most liquid of equity assets. In parallel, bid-offer spreads also widened significantly post the February VIX event, and they have not recovered, suggesting that liquidity may continue to be an issue going forward. As the name suggests, proper functioning of markets is essential for a low volatility environment. A lack of liquidity is akin to a ship trying to navigate seas without much water — accidents are likely in such an environment. For the same amount of volume traded, prices are likely to move more if there are fewer bids/offers in the market. The situation has not shown signs of improvement, and this adds to our conviction that liquidity is going to be an additional factor for equity volatility.
As ever, that doesn’t bode well going forward and you don’t have to be a criminally insane doomsday blogger, a permabear or a pessimist to come to that conclusion.
That is, this is a market structure issue – it’s not a value judgment or a subjective assessment. It just is what it is and what it is isn’t good.
The most important takeaway from the above is that all of these dynamics (systematic flows, option hedging dynamics and an acute lack of market depth) are now “in play” in a macro environment that is no longer benign. Liquidity is being removed by central banks and tightening financial conditions have the potential to be the match on the market structure kindling.