Liquidity's​ ​Effect​ ​On​ ​Volatility

The​ ​proper​ ​way​ ​to​ ​analyze​ ​potential​ ​volatility​ ​conditions​ ​looks​ ​something​ ​like​ ​the​ ​picture​ ​below: 

Current​ ​events​ ​and​ ​macro​ ​news​ ​come​ ​AFTER​ ​liquidity.

If​ ​markets​ ​have​ ​loose​ ​liquidity​ ​conditions,​ ​no​ ​amount​ ​of​ ​Trump​ ​tweets​ ​or​ ​White​ ​House shakeups​ ​will​ ​cause​ ​volatility. And​ ​if​ ​liquidity​ ​conditions​ ​are​ ​tight,​ ​no​ ​amount​ ​of​ ​good​ ​news​ ​can​ ​save​ ​markets​ ​from volatility.​ 

This ​ makes​ ​ intuitive​ ​ sense​ ​ when​ ​ ​you ​ look​ at how ​liquidity ​ impacts market​ ​ microstructure.​ Every​ ​market,​ ​whether​ ​it​ ​be ​ FX,​ bonds,​ commodities,​ ​or stock, has​ an order book with bids and offers that​ looks​ something​ like​ ​this: 

It’s​ ​just​ ​a​ ​bunch​ ​of​ ​buyers​ ​and​ ​sellers​ ​displaying​ ​how​ ​much​ ​they’re​ ​willing​ ​to​ ​transact​ ​and​ ​at what ​ price.​ When​ ​financial​ ​conditions​ ​are​ ​loose,​ ​with​ ​high​ ​liquidity,​ ​everyone​ ​has​ ​a​ ​bunch​ ​of​ ​cash​ ​and​ ​credit they​ ​need​ ​to​ ​put​ ​to​ ​work.​ ​All​ ​this​ ​demand​ ​flows​ ​into​ ​the​ ​market​ ​and​ ​stacks​ ​up​ ​the​ ​order​ ​book which compresses prices.​ A​ ​liquid​ ​order​ ​book​ ​looks​ ​something​ ​like​ ​this: 

The​ ​difference​ ​between​ ​the​ ​bid​ ​and​ ​the​ ​offer ​ is​ ​ tight and there’s a​ lot​ of size at​         ​ each price level.​ Price​ ​will​ ​bounce​ ​around​ ​in​ ​a​ ​modest​ ​range​ ​because the order​ ​book​   ​ ​can​ easily absorb any​ incoming​ ​orders. 

A​ ​liquid​ ​market​ ​translates​ ​into​ ​lower​ ​volatility​. 

The​ ​opposite​ ​happens​ ​when​ financial​ ​ ​conditions​ ​are​ tight​ ​​and​ ​the​ ​system​ ​is​ ​illiquid.​ ​Investors are no longer​ lined up to buy financial​ assets.​ They​ ​don’t​​ ​have​ ​the​ ​cash​ ​or​ ​credit​ ​available. 

During​ ​illiquid​ ​times​ ​the​ ​order​ ​book​ ​looks​ ​something​ ​like​ ​this: 

So​ ​not​ ​only​ ​are​ ​buyers​ ​and​ ​sellers​ ​farther​ ​apart,​ ​they​ ​have​ ​less​ ​to​ ​buy​ ​and​ ​sell.​ ​Price​ ​will oscillate​ ​wildly​ ​between​ ​all​ ​these​ ​different​ values ​because ​there’s​​ ​not​ ​much​ ​here​ ​to​ absorb​​ ​new orders coming into the market.​              

An​ ​illiquid​ ​market​ ​translates​ ​into​ ​higher​ ​volatility​.

This​ ​connection​ ​between​ ​liquidity​ ​and​ ​market​ ​microstructure​ ​is​ ​why​ ​we​ ​see​ ​moves​ ​in​ ​volatility follow ​liquidity​ so​ ​closely.​              

Higher​ ​black​ ​line​ ​=​ ​tighter​ ​liquidity​ ​conditions.

The​ ​last​ ​time​ ​liquidity​ ​conditions​ ​tightened​ was ​in​ ​2014 ​and​​ ​into​ ​2015.​ ​During​ ​this​ ​time​ ​the​ ​Fed was ​ winding down its​ QE​ ​​program​ ​—​ ​sucking ​​liquidity​ right​​ ​out​ ​of​ ​the​ system.​

The​ ​stock​ ​market​ ​struggled,​ ​the​ ​dollar​ ​strengthened,​ ​commodities​ ​dropped,​ ​and​ ​as​ ​you​ ​can​ ​see in ​ the​ ​ ​chart​ ​above, the VIX popped.​ It​ ​popped​ ​primarily​ ​due​ ​to​ ​tightening​ ​liquidity conditions​. 

Since​ ​then​ ​the​ ​market​ ​has​ ​adjusted​ ​to​ ​the​ ​absence​ ​of​ ​the​ ​Fed’s​ ​bond​ ​purchases.​ ​Liquidity conditions​ ​have​ ​improved​ ​ ​and​ ​VIX​ ​responded​ ​by​ ​embarking​ ​on​ ​a​ ​sustained​ ​downtrend throughout​ ​all​ ​of​ ​2016​ ​and​ ​now​ ​into​ ​2017.