2022: The Most Bearish, Illiquid Year Since Lehman?

Over the years, I’ve dedicated quite a bit of coverage to the feedback loop between liquidity, volatility and systematic flows.

Conceptually, the dynamic isn’t difficult to appreciate, despite the somewhat esoteric nature of the details.

Volatility is negatively correlated with liquidity, or market depth. Thin markets are conducive to outsized price swings, and extreme volatility can adversely impact liquidity provision, in a self-referential loop. Large moves in spot can trigger mechanical flows (e.g., from trend following strategies), and depending on the circumstances, options positioning and associated hedging can turn dealers into liquidity takers (as opposed to liquidity providers), further amplifying the price action. Erratic markets can create latent sell pressure from the universe of vol control funds, which may de-leverage on a lag. And so on.

It’s no secret that liquidity has deteriorated over the years. Although high frequency trading firms and industry “advocates” (don’t call them lobbyists), in some cases swear trends in market structure evolution are favorable, almost any basic liquidity metric you care to consult suggests otherwise.

With the above in mind, it’s worth noting that 2022 has been remarkable both for the prevalence of poor sentiment and the ubiquity of poor liquidity.

A measure of short-term sentiment developed by SocGen quants spent nearly 60% of trading days in risk averse territory during the first part of 2022, a record, according to a recent note (figure on the left, below). Note that the metric is forward-looking. The bars in the chart represent the amount of time the measure spent under a threshold below which it’s “generally a good time to deleverage risky assets and fly to safety.”

On June 15, the indicator fell below levels consistent with “extreme” risk aversion, which historically presaged recoveries over the ensuing month. US equities bottomed a few days later and have since rebounded smartly.

Not coincidentally, a SocGen indicator which measures available liquidity versus volumes in major futures markets spent a remarkable 80% of days in territory indicative of poor conditions for S&P futures during the first half (figure on the right, above).

That was the most for any first half going back to the financial crisis and exceeded readings observed during the first and second halves of 2018. That’s notable. Liquidity never recovered following the implosion of the VIX ETN complex in February of that year. The back half of 2018 was, of course, defined by a mini-bear market catalyzed by Fed tightening, geopolitical concerns and Beltway bickering which eventually led to the longest government shutdown in US history.

The relationship between sentiment and liquidity is intuitive in many respects. When a given security is severely impaired for idiosyncratic reasons (e.g., subprime mortgage debt) liquidity can dry up altogether to reflect the impossibility of valuing the assets. But it probably shouldn’t be the case that market-wide liquidity for virtually all major asset classes is some semblance of impaired virtually all the time.

That may be a straw man. But it’s not a total canard either. While acknowledging that “fragility” is a nebulous concept, the notion that markets have become more fragile over the past dozen years is difficult to dispute, and not just due to definitional ambiguity around the word “fragile.”

SocGen’s Sandrine Ungari noted that both indicators mentioned above improved lately. Earlier this month, the sentiment indicator reached its highest of the year, she said, adding that although liquidity conditions in the major futures markets are “slightly better,” they’re “still not great.”

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6 thoughts on “2022: The Most Bearish, Illiquid Year Since Lehman?

  1. Part of the reason that one might judge markets to be more fragile since the great unpleasantness, is that we know less than we would like about their inner nature, as a result of increased complexity more than any attempt at obfuscation. When what we don’t know rises we lose power and often make mistakes.

    1. Meaning, that we’ve unintentionally created an interdependent system that is complex and not truly understood? The unintended consequences would be at least similarly misunderstood, no? Then, our responses to stimuli, consequences, may compound both unintended results and additional complexity …. Same goes for policy makers, and large pro traders? T-bills, anyone?

      1. Pretty much. Especially for policy makers. Today’s many entanglements make for unexpected accidents … imo. In the old days it wasn’t so complex. My first serious publication was about how fixed income investment managers made investment decisions. Today, I’d be laughed off the stage. One of my best mates in OSU’s Finance doctoral program left with the same education I did and in four years he was managing all the Treasury’s short-term money. I can only imagine what that job is like today (or maybe I can’t). In 2009, oversimplified, who saved the banks? AIG with a huge pile of Treasury funds. We’re really lucky that worked. Now what would it take?

  2. H-Man, while markets are driven by sentiment, data determines sentiment ( positive data reinforces positive sentiment while negative data does the reverse). Data comes in two forms – economic and political. How we interpret the data determines sentiment. Economic is empirical while political is subjective. But on occasion political transitions to economic as in the case of COVID. And economic can transition to political as in the case of a new President or control of the Senate or the House.

    So trying to decipher the course of the market is simply a game of understanding current sentiment vs future sentiment.

    Which is why we subscribe to Heisenberg.

  3. My career as a trader started in 1983, after 3 horrible years trying to be a retail registered rep. I started in a low liquidity environment. Further, I worked at small private partnerships, so I was a rowboat trying not to get squashed by ocean liners. Today’s conditions are not a complete aberration, IMO. You need to know what your time horizons are, and you need to adjust these when the market tells you to. Also, you need to adress the question of leverage. There are many more, but let’s start with that….

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