In at least some respects, Monday’s egregious selloff on Wall Street was further evidence that modern markets are fragile beasts.
2018 might very fairly be described as the year when it dawned on a wider swath of market participants that the sometimes pernicious feedback loop between systematic flows, volatility and liquidity is a real thing – not just some theoretical construct yanked from a quant note and amplified by blogs of ill repute.
The volatility-flows-liquidity feedback loop was in no small part responsible for the acute selloffs in February 2018, October and December.
The mechanics of this are not difficult to grasp. The relationship between volatility and liquidity “is very strong and nonlinear e.g., market depth declines exponentially with the VIX”, JPMorgan’s Marko Kolanovic wrote in January, recapping something he’s been pounding the table on for years. That, Marko underscores, is the crux of the matter. “Given that an increase in volatility often results in systematic selling, this relationship is the key to understand market fragility and tail events”, he wrote.
Impaired liquidity is now a fixture of markets. Just ask Goldman’s Rocky Fishman, the man who, while at Deutsche Bank, penned dozens of cautionary missives warning about the potential for the rebalance risk inherent in levered and inverse VIX ETPs to one day cause a calamity (it did, on February 5, 2018).
This year, Fishman has repeatedly observed that despite 2019’s risk asset rally, market depth has never really recovered to levels seen in September, prior to Q4 rout. “Although better than it was in December, SPX futures’ top-of-book depth has been trending downward, adjusted for volatility, over the past two years, potentially exacerbating the potential of automatic flows on the US equity market”, he said, in a short Tuesday note.
Fishman writes that during Monday’s selloff, “the median top-of-book depth was approximately $11mm”. That’s down from $25mm in the five sessions ahead of the July FOMC meeting. (It was actually an improvement from Friday, though.)
Consider that in the context of the brief passages above about the relationship between market depth and the VIX, and then consider that what you see in the following simple chart represents what Fishman notes is the “fifth five-point VIX jump from a sub-20 starting point since 2015”.
Why is that stat notable? Well, because prior to 2015, there was only one such instance. That is, the VIX has risen five or more points from a sub-20 starting position just six times, and five of them have occurred in the last four years.
There are a number of things you can say about that stat, but a simple read is that it underscores the idea that markets are becoming more fragile all the time.
Indeed, Fishman also notes that if you look at days when the VIX has jumped five or more points when it wasn’t already above 30, there have been more instances in the last three and a half years than there were in the 16 years from 1994 to 2009.