Last Tuesday, in the wake of the worst day for US equities of 2019, we revisited a familiar subject: The pernicious liquidity-volatility-flows feedback look that has, at various intervals over the past two years, contributed to outsized market moves.
Obviously, selloffs and volatility aren’t new and defenders of systematic investing generally scoff at the idea that modern market structure contributes to illiquidity and sets the stage for “flash events” to occur more often than they did prior to the advent of the programmatic strategies that are fixtures of everyday market life.
Scoff as they might, it’s true. Modern market structure has made things more fragile during times of stress even if, on a day-to-day basis (i.e., during “normal” times) the upside in terms of efficiencies, etc. far outweighs the downside.
As we wrote last week in the course of highlighting the dramatic spike in the VIX that accompanied the August 5 selloff, 2018 might very fairly be described as the year when it dawned on a wider swath of market participants that the 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.
Of course, impaired market depth can also exaggerate moves on the upside and it’s entirely possible to suggest that the V-shaped recovery off the Christmas Eve lows was due in part to low liquidity in 2019. “Given liquidity, it is plausible that just short covering, buybacks, dealers’ gamma hedging, and some limited releveraging drove the entire recovery”, JPMorgan’s Marko Kolanovic wrote, in a March 21 note explaining how stocks managed to bounce so quickly in the new year on the back of the Fed’s dovish pivot.
Throughout the year, the likes of Goldman’s Rocky Fishman have observed that despite the rally, market depth never fully recovered to where it was in September. We’ve used any number of charts to illustrate that point over the last six months, but here’s a new one from Deutsche Bank that will suffice:
That lack of market depth potentially sets the stage for violent moves, especially if it collides with a favorable seasonal for volatility – as is the case in August.
Sure enough, this month has seen some eye-popping action across assets, whether in equities, rates or oil (to name three). Tuesday’s dramatic rally on Wall Street made for a stunning juxtaposition with Monday’s bloodbath and, indeed, last week saw its share of manic moves with August 7 witnessing the best intraday comeback of year for US equities.
Needless to say, bonds have experienced even more incredible action. 30-year yields approached record lows in the US this week, German bund yields have plunged, benchmark yields across the developed market world have hit record nadirs and, at one point last week, 10-year US yields had fallen some 40bps over just five sessions, the biggest five-day drop since the debt ceiling crisis (see bottom pane in the figure).
Given all of this, it probably won’t surprise you to learn that amid the swings, market depth is impaired across assets. “Even by August standards, when market depth tends to decline and volatility to rise, this month is delivering numerous unusual events and milestones”, JPMorgan wrote, in a note dated Friday.
Goldman’s Rocky Fishman breaks things down for S&P futures in a short piece out Tuesday. He previously remarked that market depth wasn’t that bad (relatively speaking anyway) during the August 5 rout, but in his latest missive, he notes that liquidity was impaired on August 7, the day of the above-mentioned U-turn that culminated in the Dow recovering a 582-point loss to close nearly unchanged.
“While liquidity is never strong when markets become volatile, in the midst of the 3.5% SPX futures sell-off on Monday 5-Aug, top-of-book depth for SPX futures was actually stronger than it had been the previous trading day [but] last Wednesday (7-Aug) represented the low-point of E-mini futures liquidity amidst a sharp intraday sell-off that later reversed”, Fishman writes.
On the bright side, Goldman notes that “top-of-book depth has been materially better than it was at the depths of December’s volatility”, although that’s not wholly surprising given that the selloff was deeper then.
For his part, Deutsche Bank’s Binky Chadha wrote Friday that “liquidity in equity futures remains very low”. Echoing other desks (and reflecting the first chart shown above), Chadha went on to say that “liquidity collapsed in early 2018 as the market sold off but even as equity markets then recovered to reach new all-time highs, remained at very depressed levels”. Here’s how things have evolved since March:
(Deutsche Bank; “yesterday” in chart header refers to last Thursday.)
In any event, the takeaway from all of this is the same as it ever was, namely that when market depth simply refuses to recover, geopolitical tape bombs and other exogenous shocks that trigger sudden knee-jerk reactions across assets have the potential to be amplified in thin markets.
When you throw in hedging dynamics (and you’ve seen hedging exacerbate moves in equities, rates and crude over the past nine months) and other systematic flow catalysts, you’ve got a recipe for “fun”.
Although we suppose that depends on your definition of “fun”.