Exactly two months ago, Goldman joined the relatively small group of voices warning that the next big market "event" (politically correct way of saying crash) could be one resulting not from excess leverage but lack of liquidity, driven by "phantom liquidity" provided by HFTs and algo traders which tend to withdraw during times of market stress, as well as central banks which have soaked up a substantial amount of the freely-traded securities in the market.
Specifically Goldman warned that "the rising frequency of “flash crashes” across many major markets may be an important early warning sign that something is not quite right with the current state of trading liquidity."
These warning signs plus the rapid growth of high-frequency trading (HFT) and its near-total dominance in many of the largest and most widely traded markets prompt us to more carefully consider the possibility (not necessarily the probability) that the long expansion accompanied by relatively low market volatility may have helped disguise an under-appreciated rise in “market fragility.”
To be sure, the topic of rising market fragility is anything but new to regular readers, and we have been covering it extensively over the past two years, although Goldman's growing concern by what was painfully obvious to many traders gives hope that one day the Fed too may be able to grasp just how its actions have broken the market, although that realization will sadly take place just moments before a market-wide flash crash send the S&P plummeting, resulting in a market that could be indefinitely halted.
Fast forward to today, when Morgan Stanley has joined the chorus of "liquidity watchers."
In a note from Morgan Stanley strategist Andrew Sheets, he writes that whereas 2017 was remarkable - "despite low
levels of volatility that made the bar for a large move relatively low, few occurred" - 2018 has been very different in that "large moves relative to expectations are becoming more common" even though it may - still - not feel that way, with volatility still low and US equities back near local highs. "And that's exactly why it's so interesting."
First, what does Sheets means by by a 'large move'? He defines it as a one-day change that is a 3-sigma event or greater, relative to what was implied by options markets at the time, in the context of 3 specific reasons:
Expectations: By comparing moves relative to what was 'implied' by options, we obtain a direct measure of the move relative to expectations. And we think it is relative to expectations that moves really matter. A 1% move when the market was expecting daily gyrations of 0.5% is a surprise. That same 1% move when the market is expecting 2% is a relief.
Scaling: Since 2000, the average daily move for oil prices is 1.5%. The average daily...