The words “liquidity” and “volatility” are constantly being thrown around by the financial media and Wall Street as if everyone fully understands them and their importance. With volatility intensifying and the Fed pulling liquidity, now is certainly a good time to explain these two concepts and the interdependence between them.

How to understand liquidity?

Liquidity is like the fuel that keeps the entire financial market running smoothly. If there is not enough liquidity, the entire financial market will stagnate, triggering a financial crisis.

Liquidity refers to the amount of money investors are currently willing to use to buy or sell an asset. A highly liquid market must have enough willing buyers and sellers of the same asset at the same time.

Now assume that only one side of the market provides sufficient liquidity.

In 2008, everyone was the one selling the subprime, and there were very few buyers. And in late 2020, early 2021, buyers of SPACs, meme stocks, cryptocurrencies, and various high-growth tech stocks far outnumbered sellers.

The 2008 example was too many sellers and limited buyers, and the late 2020 example is the exact opposite. The results of both examples tell us how important it is to have sufficient buyers and sellers at the same time in a liquid market.

In the case of Apple, the stock price is 160.12. Currently, 350 shares are intended to be sold at 160.13 and 500 shares are intended to be bought at 160.11. More than 7,500 shares were offered for sale within 5 cents of the current price. So for a retail investor looking to buy and sell 20 shares, the Apple stock market is highly liquid. The 20 shares will be traded at market prices and will have no impact on the market.

But for Buffett, he may have a different view of Apple’s liquidity. Buffett’s Berkshire Hathaway holds about 1 billion shares of Apple , and if Buffett is eager to sell even a tiny fraction of his billion shares as soon as possible, it will require a lot of liquidity.

Comparing these two perspectives on liquidity is to underscore the importance of assessing how current liquidity conditions will affect trading, but it is equally important to understand broader liquidity. It is Buffett who determines Apple’s stock price, not the trader who only trades 20 shares. So if Buffett is desperate to sell, he may have to rely on lower bidders, and liquidity will determine how much he can sell at a discount.

Volatility can be used to measure liquidity

Volatility is usually measured by realized volatility and implied volatility.

Realized volatility, or historical volatility, is a statistical measure of the price movement of an asset over a period of time in the past. Implied volatility is calculated from option prices and measures investors’ perceptions of future volatility.

Although calculated differently, these indicators quantify past and expected price movements. Also, the differences between them are sometimes noticeable. What’s more, volatility is not just a mathematical calculation. Volatility can be used to measure liquidity, and liquidity can be used to define risk.

Liquidity is variable. For example, a change in sentiment or policy can quickly alter liquidity. When liquidity is strong, many buyers and sellers can trade at or very close to the current price.

As discussed in the Apple example above, selling or buying 20 shares of Apple stock, even if you do so repeatedly, will have little effect on the stock price. In this environment, prices will fluctuate up and down as various factors change, but the fluctuations will be gradual.

Now imagine a market where for every 20 Apple shares purchased, the stock price rose 5 cents or more. In this case, liquidity is weak and prices are vulnerable to motivated buyers or sellers. In this case, the daily volatility of Apple’s stock price is much higher than that of the normal market. So it’s easy to add downward pressure to a market like this if Buffett were to sell.

It also shows that liquidity is a key determinant of volatility.

The chart below shows the CME S&P 500 E-mini futures contract price (blue) and book depth (red and green). Book depth measures how many bids and offers are on average. As you can see, when market prices are rising, book depth is deeper, indicating that investors are more willing and able to provide liquidity.

The second chart shows a bullish trend from April to December 2021 with relatively low levels of realized and implied volatility. In January 2022, market prices start to fall and liquidity wanes. During this period, book depth decreased and volatility increased.

The Fed’s Liquidity Role

Liquidity comes from buyers and sellers who are willing to trade. So sentiment, monetary and fiscal policy, and many other factors can affect the willingness and ability of these investors. Over the past 20 years, the Fed has played an increasing role in regulating liquidity.

The Fed can provide liquidity directly or indirectly. As part of quantitative easing, the Fed buys and sells bonds. In the process, they increase or decrease the securities available in the market. Withdrawing assets increases liquidity as investable dollars chase lower-priced assets.

Also, just as important is the Fed’s indirect impact on liquidity. This happens because the Fed is believed to be adding or removing liquidity, supporting or not supporting the market. Investors will feel more comfortable knowing that the Fed is adding liquidity. In the eyes of many investors, the Fed’s liquidity is a good backstop. Instead, anxiety tends to occur when they withdraw their liquidity.

Raising and lowering interest rates is another way the Fed affects liquidity. Trading on margin increases the purchasing power of buyers and sellers. Higher interest rates make it more expensive to buy assets on margin, and vice versa. The chart below shows that margin debt (leveraged speculation) tends to peak when U.S. stocks peak and bottom near U.S. stock bottoms.

In addition, the Fed controls banks, and the rules and restrictions imposed by the Fed affect capital and collateral requirements, which directly affect the size of financial market assets or loans that banks may have.

Summary: Don’t fight the Fed

Don’t fight the Fed, the phrase usually means, when the Fed provides liquidity, don’t fight it. The Fed’s liquidity may reassure investors and reduce market risk. The Fed’s liquidity has encouraged investors and increased liquidity, even at very high valuations.

Conversely, when the Fed withdraws liquidity today, it is very important not to act with them either. Increased anxiety leads to lower market depth and higher volatility.

There is no sign that the Fed’s current efforts to eliminate liquidity are nearing an end. Volatility is rising as liquidity is waning due to the Fed’s influence. An illiquid and volatile market is not conducive to long-term wealth creation.

This article is reprinted from: https://news.futunn.com/post/15550893?src=3&report_type=market&report_id=205661&futusource=news_headline_list
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