God bless anyone who, like Stephen Innes, head of trading for Asia Pacific at Oanda, gave up and went golfing last week.
I’d be willing to bet that a lot of gray hairs were generated over the past five sessions as a result of over-the-top hand-wringing and torturous attempts to divine “what is going on” across markets. I’d also be willing to bet that a lot of clicks were generated across the financial media/blogosphere in the course of breathlessly documenting every conceivable explanation for wild swings and generally erratic price action.
The silliest thing about all of this is obviously the fact that by the time you go to the trouble of making an exhaustive (and exhausting) list of every possible contributing factor, you really haven’t said anything that’s worth saying. That is, since it’s impossible to say, with any degree of certainty, whether one factor was the controlling factor, then saying “these are all the factors that might have contributed” isn’t really all that different from saying “everything contributed”, which is tautological.
Volatility obviously picked up and part of the issue is clearly diminishing liquidity. Blame casting vis-à-vis diminished liquidity is now a full-time occupation for the sellside, the buyside and pundits.
We’ve done a decent job of cataloguing the usual suspects, whether algos, balance sheet constraints, calendar effects, regulatory issues and/or the burden imposed on markets by the necessity of absorbing increased net supply of Treasurys. Obviously, some of those factors are interrelated and inextricably bound up with one another.
Whatever you want to blame, liquidity is an issue. The following two charts from Goldman paint a familiar picture (we highlighted these earlier this month, but we’re going to go ahead and use them again, since they were referenced – although not actually shown – in a popular Bloomberg article published on Friday):
Those were part of a note that found Goldman explaining that liquidity (or a lack thereof) now has a ton of explanatory value when it comes to modeling volatility.
“Simple proxies of liquidity have been valuable leading indicators of volatility [and] we find that adding liquidity factors to the model boost the R-sqrd in 2018 from 5% to 45% in 2018”, the bank said, before coming to the only conclusion that’s possible which is that “liquidity factors such as Top-of-book depth, single stock liquidity and market volumes are increasingly important for predicting volatility.”
Earlier this month, JPMorgan’s Marko Kolanovic echoed his long-standing concerns about liquidity and at this point, it’s probably getting exhausting for Marko – after all, he’s been pounding the table on this for years.
“With higher interest rates, there are also real structural risks that are significantly higher this year the most prominent one is the decline of market liquidity, as provided by electronic market makers”, Marko wrote, in his year-ahead outlook. The following chart (left pane) shows S&P futures liquidity falling to an all-time low.
“Lower liquidity is largely a result of higher volatility and higher interest rates”, Kolanovic said, adding that “in an environment of poor liquidity, any market move will be amplified, thus creating a positive feedback loop between volatility, liquidity, and the news cycle.”
We saw that dynamic play out over and over again in December.
SocGen underscored all of the above in their 2019 volatility outlook. “Even when the VIX was back close to the 10% level in August, the liquidity parameters remained severely impaired [and] what stands out to us is the depth of the order book”, the bank wrote, before marveling at how “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.”
Bloomberg quoted at least a half-dozen market participants complaining about just that in an article dated Friday.
“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”, SocGen went on to warn, in the same note. The bank also developed a proxy to complement the CME charts we’ve used time and again this month. 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.
In the top pane below is a similarly-constructed indicator. The bottom pane is just the S&P and you can see that while liquidity tends to “naturally” evaporate during selloffs, this year stands out for the extent to which it basically collapsed in February and then again in Q4.
For Goldman, the culprit for low liquidity in 2018 (or at least in late 2018) is an unwillingness among professional investors to take on risk. In other words, the bank partially exonerates machines and passive investing, if only to implicate them again at some point in the future.
“While many investors have suggested that the increase in electronic trading and passive investment vehicles has led to reduced liquidity, we believe simple risk aversion among professional investors is the more likely driver”, the bank says, on the way to flagging a number of positioning indicators to illustrate and otherwise flesh out the point. For instance, Goldman notes that futures positioning has fallen markedly since January, alongside funding spreads.
“A rise in funding cost is consistent with a rise in demand for investment leverage [as] these implied funding costs are backed out of futures and options markets providing a more real-time assessment of professional investor demand for exposure/leverage”, the bank writes, adding that “funding spreads also suggest a decline in positioning and rise in risk aversion.”
Given all of this, it comes as no surprise that markets have exhibited a propensity to chop around wildly, and it also explains why Thursday’s pension rebalance flow produced such a dramatic effect in the final hour+ of trading.
Incidentally, the NYSE TICK index that everyone cited during the course of the Thursday reversal in stocks and concurrent selloff in bonds (i.e., the rebalancing “fingerprint”, if you will) hit a new high on Friday. Headed into the weekend, folks were looking for a sequel to Thursday’s action and in a testament to how everyone is seeing what they want to see or otherwise just making sh*t up, some commentators flagged similarly stratospheric readings as “evidence” not of actual pension rebalancing, but of someone pretending to be that bid in order to, I don’t know, fool everyone, I guess. But unlike Thursday, there wasn’t a bond selloff. The yellow shaded rectangle in the bottom pane below is Thursday’s rebalancing flow and the yellow circle in the top pane represented the fourth-highest “buying impulse” (if you like) of the entire bull market. What the Friday readings (yellow shaded rectangle in the top pane) represent is actually anyone’s guess.
If you’ve gotten this far and you’re asking yourself : “Why? Why go through all of this effort to speculate on what’s driving volatility and contributing to low liquidity during a month when everyone expected a dearth of liquidity anyway, especially considering trends in market depth?”
Well, the overarching reason is that these concerns are top of mind and to the extent there are issues tied to the collision of modern market structure with onerous regulatory requirements, these are problems that we might be able to address. Even if we can’t address them adequately, we might be able to ameliorate them.
What we can’t address, of course, are issues stemming from the decision to flood the market with Treasury supply at a time when the Fed is running down the balance sheet. Part of that can be mitigated by the Fed (i.e., via a decision to calibrate balance sheet runoff to account for the uptick in net supply from Treasury as suggested by former RBI chief Urjit Patel over the summer), but the other side of that equation is Trump’s stimulus, which is something that is out of the market’s hands. Speaking of “out of hand”, the President’s general demeanor is another issue that is beyond anyone’s control, apparently even his own.
But as to the more narrow question of “Why are bloggers and the mainstream financial media so hell-bent on parsing every tick for evidence to support this or that narrative during a week when everyone knows that divining anything meaningful is impossible?”, the answer is “I don’t know.”
Coming full circle, the futility inherent in this industry-wide fact-finding mission is apparently lost on everyone except those who, like Stephen Innes, just went golfing this week. Or those who, like Walter Sobchak, just went bowling.