Beware, There Is No Liquidity In This Market, Morgan Stanley Warns

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."


Theta_Burn Fri, 03/02/2018 - 13:32 Permalink

There was a time long, long ago I would be so short this market..but being made an PPT example of forced me into market retirement..

So good luck to yawl..


Hammer823 Theta_Burn Fri, 03/02/2018 - 14:42 Permalink

I remember trading 20 years ago.  I would take short positions, expecting soft data, and if right, I would be rewarded.  That all ended in 2009.  I continued to go short, and would be right about the data, but bad data was suddenly "good".  I got burned for about a year before I figured it out, mostly out of stubborness.  I never took another short position again after 2010. I buy the dips in the am routinely, cashing out after the rigged afternoon reversal.  It's been 8 years of that strategy and I have never been more profitable. Today, yet another day of the mid day turnaround.  At least they are consistent with the rigging.  Not sure how I would go about trading a market based on price discovery again.

In reply to by Theta_Burn

lookslikecraptome Hammer823 Fri, 03/02/2018 - 15:00 Permalink

Good for u. U changed your perceptions based upon market conditions/sentiment.   Ahh stubbornness!!! The downfall of many a poker player and trader. Dude ur a trader. I admire that. Takes balls and it looks like ur day trading. Not sure I would call it rigging. Might call it taking profits the same way you do. But the big boys can pretty much push the price where they want. Follow them puppies. 

In reply to by Hammer823

Hammer823 lookslikecraptome Fri, 03/02/2018 - 15:17 Permalink

Yes, day trader...short term swing as required.  Same pattern traded over and over.  8 years now.  Today is the textbook trade.  Market falls into mid-day and then the routine reversal.  Like clockwork.

Used to buy and hold.  But Losers caught up with winners.

Used to trade options.  But Losers caught up with winners.

I'm not even that good of a day trader, honestly.

US market is just that rigged of a system.

In reply to by lookslikecraptome

lookslikecraptome 1777 Fri, 03/02/2018 - 14:53 Permalink

Some one should tell the crypto lads they r not immune to this stuff.

Crypto volume way down.   


“Merchants, payment processors and online gambling are moving off of Bitcoin,” Samani, who has $50 million allocated to the space, said in an email. “Our Bitcoin position as a fund is small -- I believe Bitcoin is in the process of failing.”

(Same Link)

In reply to by 1777

pods Fri, 03/02/2018 - 13:38 Permalink

The tanking markets over the last couple of weeks shows that when things get out of balance, the market makers just turn off their machines to avoid taking big losses.

Liquidity dries up like water on a newly-black owned SA farm after the owner washes the chrome 22's on his Escalade.


Consuelo Fri, 03/02/2018 - 13:54 Permalink

"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)."


How does the end of QE and a more hawkish Fed comport with that last minute purchase of MBS the other day - or was that simply an anomaly...?

GotGalt Consuelo Fri, 03/02/2018 - 14:55 Permalink

Consuelo - the official narrative regarding Fed MBS balance sheet is they are trying to normalize it (although at slower pace than treasury normalization).  But it's complicated as they take into account projected pre-payments to MBS occuring which means they automatically go off balance sheet without Fed doing anything.  In other words, natural tightening.  Since Fed is a bunch of cowards, they don't want this natural tightening to be too much too soon, so they are actually purchasing a bit of MBS to counter the projected pre-pays to level off the tightening.


However, actual pre-pays have come in short compared to what Fed projected, and thus their balance sheet actually grew due to their faulty analysis.  

In reply to by Consuelo

GotGalt Fri, 03/02/2018 - 14:52 Permalink

Probably just gas, but I'm sensing things are about to tilt and perhaps just maybe it is nearing time to stick it to the retail bag holders once more.  Elites quickly getting their ducks in a row, and will give the green light soon to start the purge.

katagorikal Sat, 03/03/2018 - 03:39 Permalink

So low volume spot causes higher volatility,
and higher volatility causes lower volume for volatility,
which causes higher volatility-of-volatility, 
that in turn ramps up vega, which must be invoked 
due to a severe shortage of Greek Letters.