It all started nearly 9 years ago to the day, when in April 2009 we wrote, “The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans“, in which we explained how as a result of the growing influence of HFT, quants and central banks, the market itself was breaking.
We also highlighted what the culmination of the market’s “breakage” could look like:
liquidity disruptions could and will lead to unexpected market aberrations, such as exorbitant bid/ask margins, inability to unwind large block positions, and last but not least, explosive volatility: in essence a recreation of the market conditions approximating the days of August 2007, and the days post the Lehman collapse…
We even laid out some likely catalysts for a possible market crash: “continued deleveraging in quant funds, significant pre-market volatility swings as quants rebalance their end of day positions, increasing program trading on decreasing relative overall trading volumes.”
One month ago, we saw all of the above elements briefly come together when on February 5 the market finally did break as its topology was torn apart by various, disparate elements, resulting in virtually of the above materializing, if only for a short time.
To be sure, as time passed, others joined our warning that the market is becoming increasingly broken, with some of the most notable warnings coming from the likes of Bank of America’s Benjamin Bowler…
… who explicitly noted the market’s increasing fragility on numerous occasions…
… and how the Fed rushed to bail it out on every single occasion…
… as well as Fasanara Capital…
… Aleksandar Kocic, who first defined the market’s current “metastable” state…
… and Artemis Capital, which too has been warning about the market’s growing instability for years.
* * *
To be sure, there have been many others who partially or wholly joined the “dark side” over the past decade – some at great career risk – admitting that the interplay of central bank manipulation and HFTs rigging has left us with broken markets and unfortunately we couldn’t list them all, however we do want to note that as of today, one more prominent strategist has joined the fray, none other than Goldman’s head of global credit strategy, Charlie Himmelberg, who in the aftermath of last month’s VIXplosion, asks today if “liquidity” itself has become the new market leverage – that critical leading indicator which historically has flashed red ahead of an imminent crash, and which the Fed still uses -erroneously – to guide its macroprudential decisions.
This is how Himmelberg introduces his – far less tinfoil hatted – readers, i.e., those institutional clients who still believe that the market is working as it was designed, as a liquid, efficient, discounting mechanism, to the premise that everything they know is false:
Where is there complacency in this expansion? And where might complacency be hiding unappreciated risks that will be exposed when the expansion ends or the bull market turns? We see clues in Monday, Feb. 5, when the VIX had its largest one-day move in its history, jumping from 17.31 to 37.32, a move of 20 VIX points. Like previous “flash crashes” in other markets over the post-crisis period, there was nothing in the fundamental data to explain a jump of this magnitude. Instead, we think the VIX spike was primarily a reflection of technical trading dynamics.
And while there may not have been a fundamental catalyst to the February vol eruption, the Goldman strategist picks up on what both we, and BofA’s Benjamin Bowler have repeatedly warned about, namely the market’s rising “financial fragility.” To wit:
We suspect the Feb. sell-off is symptomatic of a broader risk, namely, the rising “financial fragility” during the post-crisis period. By “fragility” we mean price volatility that arises not from changes in the fundamental outlook for markets, but rather from markets themselves.
And while Goldman’s analyst notes that various conventional indicators of market liquidity like bid-ask spreads suggest that liquidity conditions have been reasonably good during the post-crisis era, he warns that Goldman is starting to see “several reasons to worry that “markets themselves” are becoming a bigger source of market risk than fundamentals.“
And here is where Goldman in 2018 sounds like an echo of Zero Hedge in 2009, because among the factors listed by the world’s most influential bank to validate that the market is broken, is everything we have railed against for nearly a decade. As such, none of the below should come as a surprise to regular readers:
In particular, new regulations and new technologies have caused a dramatic evolution of the post-crisis ecosystem for providing trading liquidity. In this new market structure, machines have replaced humans, and speed has replaced capital. While such changes have greatly reduced the need for equity capital, and are thus efficiency-enhancing, the same was also true about leverage and structured products during the run-up to the
financial crisis. While the new ecosystem for providing market liquidity has arguably freed up equity capital for more efficient uses, it has also depleted the pools of capital that will be available for liquidity when the cycle turns.
Also, remember when back in early and mid 2009 all we warned about was High Frequency Trading, and warning how it destabilized markets (with the help of Goldman Sachs)? Well, it took Goldman nine year to reach the same conclusion:
One conspicuous consequence of post-crisis evolution is that trading volumes in many markets are now dominated by high-frequency traders (HFTs). While bid-ask spreads and other indicators of trading liquidity appear to indicate liquidity has improved in markets where HFT has grown, the quality of this liquidity has not yet been stress-tested by recession. The recent experience of the “VIX spike” suggests there is good reason to worry about how well liquidity will be provided during episodes of market distress, and this is only the latest example of a “flash crash”. Regulators and researchers increasingly warn that HFT strategies can contribute to breakdowns in market quality during periods of distress.
Right, and tinfoil hat wearing blogs have been warning about it long before it became cool.
Ok fine, but despite all the warnings, every time the market tumbled, flash crash or otherwise, it managed to rebound, so why should that change? Two answers: the first one came from Bank of America, which in December showed that “In Every Market Shock Since 2013 Central Banks Have Stepped In To Protect Markets.” The other is from Goldman which writes that so far, the “strong fundamental backdrop”, i.e., massive global releveraging, offset the market weakness. That, however, is coming to an end.
So far breakdowns in the new liquidity ecosystem have been short-lived and relatively benign, in part, we suspect, because the fundamental backdrop has been strong. But under alternative scenarios where fundamentals have deteriorated, we worry that a future such a collapse in market liquidity could amplify sell-offs. This could contribute to price declines and possibly prolonged periods of financial instability in ways that are reminiscent of the price declines caused by financial deleveraging.
If Goldman’s “epiphany” is right, and it is, it has profound consequences for virtually every aspect of macroprudential regulation, first and foremost that it is no longer leverage that matters, especially since most of its has been directly onboarded by central banks, but rather liquidity is the only critical variable.
While the analogy is imperfect and our uncertainty is high, we see reasons to think that “liquidity is the new leverage”. Like financial leverage during the previous cycle, the rapid evolution of the post-crisis market structure has been a period of exciting technological innovations, but also one of low volatility and untested complexity.
Goldman’s conclusion: those seeking an exogenous catalyst to the next market crash will be disappointed, as the next crash will come from within the broken market itself:
Along with the uncomfortably high number of flash crashes in most major markets, we think “markets themselves” belong on the short list of late-cycle risks to which markets are potentially complacent.
While Goldman ends on a relatively optimistic note, suggesting that an “endogenous” crash is not imminent…
Over the foreseeable horizon, of course, these risks from “markets themselves” are just risks, and we think investors will be forced to cautiously own the risk opportunities on offer.
… we suggest that this is certainly not a given, and for those asking what happens when the market officially crosses beyond the “liqudity” event horizon, we will leave with what we said back in April 2009, as nothing has really changed since then:
“what happens in a world where the very core of the capital markets system is gradually deleveraging to a point where maintaining a liquid and orderly market becomes impossible: large swings on low volume, massive bid-offer spreads, huge trading costs, inability to clear and numerous failed trades….
the consequences will likely be unprecedented, with dramatic dislocations leading the market both higher and lower on record volatility. Furthermore, high convexity names such as double and triple negative ETFs, which are massively disbalanced with regard to underlying values after recent trading patterns.“
February 5 was just the preview of the main event.
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