Goldman: Liquidity Hasn’t Been This Bad Since COVID Crash

US equities have been a veritable roller coaster lately. Maybe you noticed.

Tuesday was no exception. Another aggressive upside move into the close left the S&P with its best three-day gain since 2020 (figure below). The world’s risk asset benchmark par excellence has now retraced half of its January peak-to-trough decline.

The same dynamics that contributed to Monday’s epic squeeze were doubtlessly in play. It helped that Jim Bullard joined the chorus of Fed officials actively seeking to talk markets out of fully pricing a 50bps rate hike for next month’s meeting.

When you think about the wild swings and dramatic reversals that characterized January’s price action, it’s critical to note that the mechanical flows and hedging dynamics so often cited in these pages as accelerants are amplified by low liquidity.

Remember: Volatility is inversely correlated to market depth. And one way or another, volatility is the exposure toggle for every investor cohort that matters. Hopefully, you can discern why that has the potential to be problematic. As volatility rises, market depth deteriorates. Mechanical flows hitting a thin market are conducive to exaggerated price action. Exaggerated price action begets still more volatility. Liquidity then dries up further, leading to even larger swings, which then risks pushing spot through key trigger levels for trend following strats, prompting more mechanical flows, and so on.

According to Goldman’s Rocky Fishman, liquidity is now nearly as poor as it was during the initial pandemic drawdown. “Our biggest technical concern is liquidity, with SPX futures’ liquidity resembling March 2020,” he wrote, adding that “on-screen liquidity has become so poor that futures have been more than one tick wide over 20% of the time.” The figure (below) makes the point.

He went on to reiterate that “weak liquidity means flows matter more, and leaves the potential for outsized market moves (in both directions).”

In case that was somehow unclear, Fishman drove it home. “Low liquidity raises the stakes for systematic fund positioning,” he wrote, cautioning that “increased volatility (implied and realized) is now in a range associated with managed vol funds reducing equity risk, and that sizable flow has the potential to impact markets more than it would if liquidity were stronger.”

That’s why it’s important for daily moves to settle back into a range. If the distribution of outcomes can compress, realized vol can recede, hopefully turning the vol control de-allocation impulse in equities into a bid for stocks instead.

When all of the factors alluded to above are in play simultaneously, it’s impossible to get a “clean” read on markets, something JPMorgan’s Marko Kolanovic emphasized this week. “As long as S&P 500 remains below ~4,600, gamma is negative with dealers buying on strength and selling on weakness,” he wrote, adding that “this would amplify market moves, especially in the current low market liquidity/depth environment.”

In a Monday note, Nomura’s Charlie McElligott wrote that market participants felt the short gamma hedging dynamic last week. It’s “contributing to the violent and ‘chase-y’ moves both higher and lower,” he said.

The figure (above, from Nomura) is one of my favorite visualizations. It’s updated to depict January’s fireworks.

Kolanovic and his colleagues elaborated further, touching on the same points as Goldman’s Fishman. “Proxies for market depth, market breadth and the share of ETFs in equity trading are all pointing to severe deterioration in liquidity conditions this year to levels last seen in March 2020,” JPMorgan said.

Simply put, if you’re looking to extract meaning or divine something profound from a given day’s price action, it’s an exercise in futility.

As Kolanovic put it, “this poor liquidity picture raises the probability of large equity market moves either way, and we thus advise clients to not get carried away by short-term fluctuations in equity markets and to instead focus on the longer-term picture.”