As the recent swoon in the S&P showed, the lasting pain from the February vol unwind has combined with multiple policy shocks to weigh on markets. We showed the concurrent impact of the various catalysts leading to the current risk off environment with the following DB chart:
However, while the early Feb swoon was largely the result of the "Quant Quake", the transmission mechanism in this move lower is no longer systematic funds / vol target strategies, according to Morgan Stanley's Chris Metli. Instead, the MS executive director notes that this time selling has come from more fundamental/discretionary investors – the MS PB Content team has noted that there were multiple large sell days from L/S HFs this week (versus buying the week of Feb 5th ) – exacerbated by a lack of liquidity.
Here the lack of liquidity is important.
As the MS Futures team has been pointing out since the start of the year, available size at the top of the book in the US equity futures market - i.e. how many futures can trade without impacting price - has deteriorated sharply and has remained depressed since Feb 5th. In fact as shown in the chart below, using that metric, market liquidity is now the worst since the financial crisis. There are similar signs of reduced size / wider spreads in cash and options markets as well.
As MS notes, part of the decline in liquidity is a natural function of higher volatility – spreads usually widen and available size drops when volatility increases. But the recent decline in liquidity is sharper than typically happens when volatility spikes – based on data since 2011, available size in ES futures is 3 standard deviations too low right now versus where VIX says it should be.
There are several potential drivers of the liquidity deterioration. The first is that market makers took substantial losses on the vol shock. In the options market, dealers likely had to buy over $100mm of vega to cover short vol positions that were moving against them. When market makers take losses, the natural step is to pull back and provide less liquidity.
The second cause for plunging liquidity is that there is less vol supply now, which means volatility moves higher faster as spot declines, which then feeds back into liquidity, etc. The increase in volatility and unwind of short vol exposures in early February meant that volatility sellers took losses, and as a result have pulled back on supplying volatility to the market.
The third reason is more structural – as markets have become more fragmented and more volume has shifted to closing auctions, there is less natural liquidity during the trading day.
The final potential culprit are tighter financial conditions/higher cost of capital, especially in the form of surging FRA-OIS which we have documented in recent days. Whether this is actually impacting the ability of market makers to provide liquidity is unclear – but tighter financing certainly increases the fragility of the market. The bear case, MS notes, is that this is a function of a more hawkish Fed combined with the end of QE (which most market participants have stopped talking about).
Yet while liquidity is abysmal, there risk of violent moves as a result of systematic fund deleveraging is also lower. That said, there is some risk remaining from the systematic / vol community though according to MS:
- Of all of the systematic funds, risk parity funds likely remain the most levered, and could bring supply – but the key risk for them is higher stock-bond correlation, which QDS does not think is likely just yet (see Don’t Fear a Little Inflation, Yet from Feb 26th 2018)
- Institutional short volatility strategies have largely remained invested throughout the last month – should volatility remain higher for longer (as QDS thinks it will) there could be covering here
So what happens next? As Morgan Stanley summarizes, to some extent this selloff is following the usual playbook – when market participants feel enough pain from the initial shock, markets retest the lows and volatility stays higher for longer. The path forward in spot will be driven by:
- How fundamental investors weather this storm – no signs of panic yet, but as they give up more and more performance their resilience will be tested
- Financial conditions and whether market makers can get some relief
The bank's conclusion: "given the instabilities and lack of liquidity in the market, investors should be wary to catch a falling knife and wait for some stability before aggressively buying. With VIX already in the high 20s, QDS continues to think longer-dated and forward volatility is a better buy."