Watch Out: The Fed is Removing Liquidity from the Markets

Liquidity is the fuel that keeps the financial market's engine running. As we have seen, without enough liquidity, the motor seizes, and financial crises erupt.

Liquidity refers to the amount of money investors are willing to use to buy and sell assets now. As you might surmise, the more investors willing to bid and offer assets, the more liquid the market. I cannot stress the word "and" enough. Liquid markets must have both many willing bidders and offerors of an asset.

What happens if only one side of the market offered good liquidity?

In 2008, everyone was a seller of subprime mortgages, while buyers were few and far between.

In late 2020 and early 2021, buyers of SPACs, meme stocks, cryptocurrencies, and an assortment of high-growth tech stocks dwarfed the number of sellers.

The 2008 example highlights a surplus of sellers with limited buyers. The more recent example is the opposite. In hindsight, we know how both illiquid conditions ended up. That is why it is vital for a liquid market to have ample buyers and sellers.

Liquidity is in the eye of the transactor

As I write this article, the price of Apple stock is 160.12; 350 shares are offered at 160.13, and 500 are bid at 160.11. Within five cents of the current price, well over 7,500 shares are bid and offered. For a retail investor looking to buy or sell 20 shares, the market for Apple is incredibly liquid. Said transaction will occur at the market price and have no effect on the market.

Berkshire Hathaway owns approximately 1 billion shares of Apple. If Warren Buffett has a hankering to sell even a small portion of his shares, he will have a different opinion of Apple's liquidity.

The point of comparing these two opinions on liquidity is to stress the importance of assessing how liquidity conditions affect your trading, and to understand broader liquidity. The Warren Buffett's of the investment world dictate the price of Apple, not our 20-share trader! If Buffett is desperate to sell, he will likely have to rely on bidders at lower prices. How much lower is a function of how much liquidity there is.

Liquidity defines risk!

Volatility

Volatility is often quoted in two ways, realized and implied.

Realized, or historical, volatility is backward-looking. It is a statistical measure of an asset's price movement over a prior period.

Implied volatility is derived from options prices. It is a measure of what investors think volatility will be in the future.

While calculated differently, they quantify the movement of prices, past and expected. Further, and a story for another article, the difference between them can sometimes be telling.

More importantly, volatility is not just a mathematical calculation; it measures liquidity! And liquidity defines risk?

Volatility measures liquidity

Liquidity is variable. Changes in sentiment or policies, for example, can quickly alter liquidity. When liquidity is high, many buyers and sellers are poised to act on prices at or very close to current market prices.

As I discussed in my earlier example, selling or buying 20 shares of Apple, even if done repeatedly, will have little to no effect on price. In such an environment, the price will move up and down as factors change, but the movement will be gradual.

Now consider a market in which each 20-share purchase of Apple moves the stock by a nickel or more. Liquidity is weak, and prices are susceptible to a motivated buyer or seller. In such instances, daily price moves in Apple are much more elevated than in the liquid market example. Buffett could easily introduce significant downside pressure in such a market.

This example shows how liquidity is the critical determinant of volatility.

Evidence

To help better cement the concept, I provide actual data.

The first graph below from the CME shows the S&P 500 E-mini futures contracts price (blue) and its book depth (red and green). Book depth measures how many bids and offers, on average, are available. As you see, when markets are rising, book depth is deeper. Investors are more comfortable, willing, and able to offer liquidity.

The second graph shows the bullish trend from April through December of 2021 had relatively low realized and implied volatility. In January 2022, markets started falling, and liquidity gave way. At that time, book depth weakened, and the volatility readings rose.

Fed's liquidity role

Liquidity comes from those investors who are willing and able to buy and sell. Sentiment, monetary and fiscal policy, and a host of other factors affect the willingness and ability of investors. Over the past 20 years, the Fed has played a more prominent role in regulating liquidity.

The Federal Reserve does and doesn't directly provide liquidity. They do purchase and sell bonds. In that respect, they add or subtract securities available to markets. More important is the Fed's indirect influence on liquidity. This occurs via the perception that the Fed is adding or reducing liquidity and supporting or not supporting markets. Investors feel more comfortable knowing the Fed is adding liquidity. It's an excellent backstop in many investors' opinion. Conversely, as we see now, angst occurs when it removes liquidity.

Raising and lowering interest rates is another way the Fed affects liquidity. Higher rates make it more costly to buy assets on margin and vice versa for lower rates. Trades using margin increase the purchasing power of buyers and sellers. The graph below from Jesse Felder shows that margin debt (leveraged speculation) tends to peak at market tops and troughs near market bottoms.

Lastly, the Fed regulates the banks. Its rules and restrictions affect capital and collateral requirements, which directly influence the volume of financial market assets banks may own and or make loans against.

Summary – Don't fight the Fed

We often hear, "don’t fight the Fed”. What this means is that when the Fed is providing liquidity, do not fight them. It is likely the Fed’s liquidity will pacify investors and result in a less risky environment. Fed liquidity emboldens investors and adds liquidity, even when valuations are extreme.

Conversely and incredibly important today, when the Fed is removing liquidity, do not get in its way. Anxieties are increased, which results in reduced market depth and increased volatility.

There is no sign the Fed's current quest to remove liquidity is close to ending. Liquidity is fading due to the Fed, and therefore, volatility is on the rise. Illiquid and volatile markets are not conducive to long-term wealth generation.

Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.

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