Let’s take a step back for a moment to ponder where things stand.
The VIX is sitting at a post-February high. Investors are reeling after one of the worst weeks for U.S. equities since the crisis. The U.S. government is shuttered at Christmas in lieu of $5 billion in taxpayer ransom money earmarked for the construction of a 2,000-mile “steel slat barrier” (with spikes on top) along the southern border. The Secretary of Defense has resigned. The President of the United States is under investigation for colluding with the Kremlin. And markets have succumbed to multiple one-day crashes facilitated, at least in part, by systematic flows and an acute lack of liquidity.
We are now living in a collage of surreal, dark geopolitical and market fantasies, each of which could, on its own, serve as the plot for a thriller. And we’re experiencing them all together, at once.
Below, I’m going to zoom in on liquidity and market depth but I hope you’ll read this with the broader context (as briefly summarized above) in mind. To that end, I attempt to bring it all together in the concluding remarks.
Beating the dead liquidity horse
I’m going to keep beating this dead horse until it dies a second and third and fourth time. I’ll deploy an adapted version of one of my all-time favorite Heisenberg lines. To wit:
Although “posthumous equine abuse” isn’t something I’d list under “interests” if I were say, signing up for a dating site, I don’t mind engaging in it if I think doing so might drive home a particularly important point.
For years, the doomsday blogs have been pounding the table on the impact of systematic flows, electronic market making and deteriorating liquidity. Some of those same portals have variously warned that the self-fulfilling nature of those dynamics would eventually conspire with the rolling back of central bank liquidity to create a particularly precarious backdrop.
Although they aren’t right about much, those portals are precisely correct about this issue. The problem is that anyone with any sense stopped taking them seriously years ago and so, their warnings increasingly fell of deaf ears.
That’s a shame (it’s also ironic) because in 2018, these dynamics have started to bite, with February 5 and October 10 being the most notable examples.
Gamma gravity (redux)
What I want to do here is expand a bit on something we published Thursday called “Matches, Kindling And Ships In Shallow Seas“. In other words, this section is an addendum to that, so you may want to read it if you haven’t already.
In that linked piece, we cited SocGen’s 2019 volatility outlook and in the appendix to the bank’s note, they offer a handy explainer for anyone who isn’t familiar with how option hedging dynamics can, under the “right” (or “wrong”, depending on how you want to look at things) circumstances, turbocharge upside and downside price action.
Honestly, I didn’t read that far into the note when I penned the “Matches, Kindling” post because who has time to read the appendix of a sellside note when Donald Trump is busy shutting down the government over “steel slat” funding, am I right? Of course I am – “a wise guy’s always right.”
Well, here is SocGen’s brief explainer, which I imagine will be highly useful for some fans who, at various intervals over the past three months, might have felt like I was speaking gibberish to them. To wit, from the bank:
For readers who are not aware of the concept of gamma hedging by dealers and the impact it (theoretically) has on index moves, we summarize it in the following few sentences. When an investor sells an option to a market maker, the market maker is in turn long gamma (a long position in both puts and calls have positive gamma). The delta hedging activity from the dealer is such that he or she needs to sell the index when the spot moves up and buy it when the spot moves down. If this selling or buying volume is large, it may impact the spot market by dampening the moves that would be otherwise expected fundamentally. The opposite is true when the investor buys an option from a market maker, thereby making the market maker short gamma. In this case, the hedging activity leads to the exacerbation of market moves. Due to the well-established preferences of the average investor (selling calls to generate additional yield, buying puts to protect from drawdowns), one can assume that dealers, on average, are long all the call options and short all the put options. While this is an oversimplification and market moves are obviously impacted by many other factors, anecdotal evidence suggests that this analysis has some value.
Ok, so now that you understand that, you can understand why the following charts present something of a problem for investors hoping for a reprieve from equity volatility both in the U.S. and across the pond. In the left pane below is SocGen’s estimate of SPX dealer gamma as of December 14 and in the right pane below, the same visual is presented for the SX5E.
Note where the indexes were trading when those charts were made (teal annotations). “If we look at the current distribution of net call-put gamma across strikes on the S&P 500 (index and ETFs), we find that there are large negative balances around the current strikes (below 2,650)”, SocGen writes, describing the visual on the left, and adding that “if the spot remains in this range, the index looks set to experience large intraday moves, and this should continue to put a floor under short-term volatility unless the S&P 500 escapes to above 2,650.”
Obviously, those charts are not static, but the bank’s point stands. Since the distributions shown in those charts were current (i.e., on December 14), the S&P has fallen more than 7% and the Stoxx 50 is down more than 3%.
SocGen does note, however, that despite the “significant” net gamma imbalance shown on the right (in their charts), “Eurostoxx50 volatility remained relatively contained” and the bank also reminds you that recently, “much of the flow on the S&P 500 has been on the upside, with investors buying calls financed by selling puts, the opposite of the traditionally expected flow.” The point: You can’t simply look at their charts and base your entire investment thesis on them, and while the bank has to include that caveat in their note, I certainly hope it goes without saying that you should never make an investment decision solely based on one factor. That’s not the point here. The point, rather, is to highlight the potential effect this dynamic can have on exacerbating market moves.
Incidentally, this is the same dynamic that helped drive the three dramatic one-day plunges in crude prices last month.
Read more about how gamma effects facilitated crude’s collapse
What’s especially vexing about this is that CTAs have the potential to exacerbate this situation by pushing prices into key strikes. That was on full display in crude last month when momentum chasers drove prices through levels tied to producer hedges.
As if that weren’t enough, a lack of market depth/liquidity means that when things get moving in the “wrong” direction, the market is ill-equipped to absorb the shock.
“Whether it’s due to continued structural changes in the market microstructure over the past couple of decades (higher proportion of algorithmic trading, reduced number of shares outstanding in listed equities, smaller dealer balance sheets due to regulatory requirements) or more of a late-cycle phenomenon, the diminishing liquidity in equity markets has been difficult to ignore and has severely diminished since the February VIX spike”, SocGen writes, in the same appendix mentioned above.
Allow us to visually reiterate this via the following high-rez version of a chart we used earlier this week. What you’re looking at below is (basically) market depth for S&P futures. We’ve slapped the mid price on top of it to help you see how liquidity evaporates during selloffs.
What happens if you overlay the bid/ask spread on that? Well, this happens:
Now, consider that in conjunction with the following two updated visuals from Goldman’s Rocky Fishman which give you a more granular view.
Long story short, this is getting worse over time. Here’s what the situation looks like for Nasdaq futs:
And here’s crude:
Clearly, this is a problem and it will become an even bigger problem if/when anyone tries to transact in size. SocGen underscores this. Here is the bank’s assessment of the S&P and Nasdaq futures charts shown above:
Even when the VIX was back close to the 10% level in August, the liquidity parameters remained severely impaired. What stands out to us is the depth of the order book. Even with VIX falling back close to 10% in August this year and bid/offer spreads almost completely normalizing, at least temporarily, the size of the order book has not shown any signs of reverting to the levels from last year, suggesting that this may continue to be an issue for investors trying to push through large-sized trades. This is likely to be especially problematic if large multi-asset funds try to reallocate out of equities to prepare for the end of the cycle.
The bank also develops a proxy to complement the CME charts. Specifically, SocGen takes total turnover and divides it by the mean true range of a given index. The lower the number, the worse the liquidity. Given the above, it probably won’t surprise you to learn that the trend is “worse” (so to speak) and we’re now sitting near a post-crisis nadir.
The point in all of the above is that these conditions will contribute to higher volatility – indeed, they already are. You’ve seen it over and over again in 2018 and the fact that it appears to be getting worse is a testament to the self-fulfilling nature of this dynamic. The less liquidity, the more volatility, and the more volatility, the less liquidity. It is a pernicious loop.
Fortunately, this situation doesn’t appear to be prevalent in Treasurys, although that’s likely to be small comfort. “It seems like liquidity is more of an issue with risky assets, especially in US equities”, SocGen concludes.
Yes, it does seem that way, and it also “seems” like a particularly dangerous setup at a time when the market pretty clearly believes that an economic downturn is right around the corner along with possible impeachment and/or indictments for more of the President’s associates (and possibly even for some of this family members).
On Friday, John Williams did his best to “right” Jerome Powell’s Wednesday “wrongs”, but it made no difference for the market, which sold off hard on political worries, a testament to the idea that the Fed isn’t the only problem here.
When market fiction becomes reality
The difference between me saying all of the above now and the other people saying it 5 years ago, is that it’s all some semblance of real now. The charts above are current. When it comes to geopolitics, note that my assessment of the prevailing domestic political environment is more fact-based than my Republican readers are willing to give it credit for. I am, simply put, stating facts.
Bringing it all together, I’m not extrapolating about a hypothetical crash that’s nowhere on the horizon (as some portals have spent the last decade doing). In the same vein, I’m not ranting and raving about purported geopolitical conspiracies which don’t actually exist. These are all real things in 2018 and it seems likely that they are going to get even more “real” in the new year.