Last week, I talked a bit about market depth and a seemingly acute dearth of liquidity in the context of recent lamentations about exaggerated price action.
In a recent note, Goldman’s Rocky Fishman called liquidity the bank’s “biggest technical concern.” In SPX futures, liquidity resembled March of 2020 during the recent selloff. Comparisons to March of 2020 are never a good thing.
“Low liquidity raises the stakes for systematic fund positioning,” Fishman said, cautioning that exposure reductions from managed vol funds can have a bigger impact when liquidity is weak.
JPMorgan’s Marko Kolanovic made similar remarks. “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,” he and his colleagues said.
In the linked article (above), I revisited the “doom loop.” To briefly recapitulate, volatility is inversely correlated to market depth. And one way or another, volatility is the exposure toggle for every investor cohort that matters. 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. When the distribution of realized daily outcomes widens, trailing realized volatility is pulled higher, creating a latent “sell” impulse from the vol control universe, which can weigh for days or even weeks.
That domino effect (or some version of it) has been responsible for a number of memorable “cascades” (as it were) over the past half-decade.
In a Tuesday note, Nomura’s Charlie McElligott took a moment away from documenting current macro developments and updating positioning estimates to explain how dealer hedging is embedded in the feedback loop briefly described above.
The three bullet points below are excerpted from McElligott’s latest missive and serve as a handy reference guide for those interested in how one of modern market structure’s “core truths,” as he put it, works behind the scenes to amplify or dampen directional moves depending on the circumstances and setup.
- In my eyes, a core “truth” to modern market-structure is that “Dealer Gamma” is the primary input which matters as it pertains to the ongoing cries from market participants about the current “horrible liquidity” environment with no “depth-of-book” — because a “Long / Positive Gamma” position means that prolific $ options hedging flows where Dealers can function as “liquidity PROVIDERS” — “countercyclical buffers” which tend to sell into strength (“offer” futures / stock when there is high demand), or buy into weakness (provide the “bid” for markets to hit into selloffs)
- But where “Long Gamma” regimes often see extended periods of “low Vol,” moments of eventual “market truth” occur (e.g. Fed pivot, COVID growth shock, Trump Tariff tweets) — and spikes in implied Volatility then follow, as the prior “stability” sows the seeds of “instability” via leverage and lazy-narrative “crowding,” which tends to then see “asymmetric” positioning tip over thereafter
- These “Vol spikes” then coincide with the Dealer Gamma position vs Spot markets moving abruptly lower (or the most extreme scenario, outright negative in this most recent period), as generically, Dealers being “short Puts” into said Vol spikes sees market Liquidity then REMOVED (iVol up, Gamma down, Delta down) — i.e., Dealers are same-way “liquidity TAKERS” as client flows in “negative / low / short Gamma” position — either acting as another seller on the way down (with few MM bids to hit), or buyers on the way up (when there are few offers around) — thus my usage of the term “accelerant flows” from Dealers as it pertains to a “short Gamma” regime, instead of the “countercyclical liquidity provider” role they play in a “long Gamma” environment.
