The Liquidity Trap
A Misnomer in Several Ways
n a week that saw the EM currency crisis extend to South Africa and India, continuing trade war tensions including comments on Friday from President Trump about even more tariffs on China, and the market spike down on an NFP beat, yet Amazon broke the $1Trn mark, there are several drivers that seem to account for seemingly disparate divergent and different moves. Making sense of this market may seem a challenge. US Stocks and USDCAD and USDJPY bulls can rightly point to the US Cinderella economy, rising rates and Donald Trump’s impact on trade relations for a somewhat disjointed US uptrend. And yet fears over continued trade war escalation, Brexit unease and general European political instability alongside Emerging Market shivers are enough to keep alive the hopes if not reality of a European, Asian, Emerging market and consequently global fall out.
As we have highlighted such a correlation break down and divided market was a feature of both the 1929 and 1987 stock blowouts and crashes. A growing distrust explained and continues to explain why traders and investors jump from one hot instrument to another leaving the ‘dogs’ such as the German DAX out in the cold. Such divergence is likely to continue until they are unwilling or unable even to chase the FAANG or other hot markets. When that will exactly happen may appear to be a movable feast. But it is when markets start to re-converge and liquidity dries out, opening the floodgates and leaving all markets vulnerable. A possibly wrongly termed Liquidity Trap.
In today’s newsletter we explain why liquidity may conceptually appear an important and often referenced market variable and yet is difficult even to understand let alone measure and apply.
Market liquidity has a myriad of inputs and drivers, but, for many, boils down to a simple concept: how easy it is to buy and sell. If you like it is a transactional rather than analytical concept. Difficulty selling usually causes the most pain, and understandably gets the most attention, but failure to get filled on a buy can be a frustrating experience. However, where it can be an arguably more useful guide is as a proxy for sentiment. In this respect it is very similar to volume. As a new uptrend develops increasing numbers buy increasing amounts adding volume and liquidity to sustain the rally and provide support on dips. In a stock market uptrend the fundamental inspiration for rising stocks in the form of higher earnings and in this US instance as we have seen tax breaks and fiscal expenditure also provide greater volume and liquidity. However, as the price rise discounts both the fundamental improvement and also the increased stock purchasing power, the rally falters, volume decline and liquidity becomes sporadic as correlations break down and markets spikes on relatively lower volumes. The story of much of 2018. It is when this then gives rise to a final new high that we actually see liquidity fail to increase or even start to decline and volume only truly recover in the very final stages. In this respect January 2018’s blowout can be seen as a dress rehearsal for the blowout and top that we are yet to see: a liquidity trap.
Liquidity in the market tends to only become an issue when it suddenly dries up. There is usually a constant background of buying from funds, corporations (buybacks) and even central banks. Much of this is passive buying regardless of price action or changes in fundamentals. Only the largest of holders will have issues with liquidity on a normal day.
But not all days are normal…
Memorable crashes such as 2008 and 1987, but more recently the flash crash in 2010 and to a lesser extent August 2015 and even early 2018 saw liquidity evaporate. Low liquidity leads to air pockets, a phenomenon we have talked about before. An air pocket is where the market cannot find an equilibrium so continues to gap down because there are not enough buyers to absorb the extreme panic liquidations (see Edgar Peters’ Fractal Market Hypothesis for one of the best explanations of price movement). This subsequently led to the encouragement of HFTs and the like to provide continual liquidity to avoid a recurrence of the air pockets. Can they stop a crash? No. They can provide more bids to be hit to make the decline more orderly. But the growth of the VIX market and potential liquidation of short volatility positions suggests firstly it will not be stopped and secondly air pockets and therefore gaps are more likely to occur outside NYSE trading hours.
This high volatility, low liquidity decline does not only affect large holders. Even the smallest retail sell stops could experience huge slippage, and the effect of multiple leveraged retail traders can snowball into a big problem. Forex brokers going bust after the EURCHF crash is testament to this.
Liquidity is not only a consideration to us because of trade executions, but it also helps us navigate the market. For instance, gaps and areas of low liquidity have a habit of being re-tested. This can help our analysis of market direction and give us targets for trades (i.e. a target of gap fill). Volume can also add to our overall understanding of a market.
The rise in volume in January was a significant event. The cause was clearly the tax bill, but the cause was mostly irrelevant; we know that a pick-up in volume and acceleration in prices often mark the end of a trend sequence. It told us to expect a reversal (although only in a broad concept – the exact level cannot be derived from volume alone), and it also gave us a target for the reversal i.e. where the high volume move originated.
Volume and liquidity are similar in concept, but the development of dark pools, and the amount of volume in options and other instruments means it is hard to track reliably. Also volume will show the amount of transactions which have taken place, but won’t show if there was a limitation on this due to lack of liquidity, or similarly, how much “spare” liquidity there is in the system not being used. While the potential liquidity is huge, it is finite, and understanding it can give us insight into the way price is likely to move.
Again, tracking all sources of liquidity is no small challenge. The Fed partially controls the money supply (M2) through the monetary base. The policy of quantitative tightening has decreased this as the Fed lets up to $40 billion of its bond holdings (soon to rise to $50bn) mature every month without replacing them. As the Treasury Department needs to then find new buyers for its debt (which is actually rising), there is less money in the system.
The decrease in liquidity can actually be tracked and there is a scheduled run-off.
There are theories this can have an immediate effect on the market when particularly large bonds mature, although there is patchy evidence of this. The latest maturity date on 31st August actually saw a small rise in the S&P 500.
Nevertheless, the broader effects are apparent.
M2 growth is falling fast.
However, the effect of this is slow to spill over into the stock market, partly because other central banks are still easing. The Bank of England are buying corporate bonds in US firms such as Apple, AT&T, and Amgen, and this money can then be used to buy back stocks, thus increasing liquidity. The SNB are openly buying US stocks and its US stock holdings increased in Q2/18 by 6.64% to an incredible $87,453,764,000. Yet this too is set to decrease as the ECB and BoJ taper. The collective balance sheet of the Fed, BoJ and ECB may have peaked in March.
Again the effect of a reduction in liquidity (and higher rates) may not be seen immediately in the stock market, but there are subtle signs in related instruments. AAA corporate bond yields are still low, but have broken out of the downtrend. This obviously puts pressure on corporations who have had a steady supply of cheap debt to buy back stocks.
Meanwhile the spread between treasuries and BBB rated corporate bonds has made a sharp move higher this year. Higher risk premiums suggest some strain is being felt.
It may be some time off, but this will eventually have a significant effect on the market. Tom Demark’s theory is that “market tops are not made because omniscient top pickers or informed trading syndicates with massive financial resources co-ordinate their selling campaigns; rather a diminution in buying occurs at that particular point in time and price declines of its own weight.” He calls this “buyer exhaustion”, but it could also be described as a lack of liquidity. And as we have seen, it gets worse as the decline picks up speed. Falling liquidity was not only a feature of the 1987 crash, but there were signs liquidity was actually declining from the beginning of 1987 during the ramp into the top.
It’s actually worth looking at this next to today’s chart.
Liquidity and/or volume is a difficult concept to apply as it is neither uniform or easily measured. However, its importance to the final legs in 1987 and other uptrends, suggests it will be worth monitoring into the final quarter of 2018. Just like the buy back, it will be a feature of the blowing and timing the very top. But it will also be critical in the downturn in air pockets—but that is another story, for another day.
Here’s to making the very best. Good luck and Good Trading
Ed Matts, Founder, and Andrew McElroy, Chief Stocks Analyst