Derivatives markets and speculators responsible for market liquidity, not the Fed
Investing.com -- Liquidity in the financial system is not coming from the Federal Reserve, but from derivatives markets and speculators, according to Tom Essaye, founder and president of Sevens Report.
When the COVID-19 pandemic began in 2020, central banks around the world had flooded markets with liquidity in order to prevent a collapse, while also dramatically increasing their balance sheets. The Federal Reserve led the way, but the U.S. central bank has since 2022 been steadily shrinking its balance sheet.
“A subscriber wrote in with an interesting inquiry regarding the correlation between the Fed’s balance sheet and the S&P 500 since 2009. He specifically pointed out that the S&P 500 has typically risen when the Fed’s balance sheet is expanding, and vice-versa, from 2009 through 2022,” Essaye said in a research note on Friday.
“That makes sense as a supportive Fed stance and quantitative easing favor high-liquidity market environments. Conversely, a declining Fed balance sheet has coincided with spikes in broad market volatility and sharp declines in equities amid lower market liquidity conditions,” he said.
But Essaye noted that since the late-2022 Wall Street lows, the positive correlation between the balance sheet and the border stock market has not been holding up.
“So, the critical question to ask is: Where is the liquidity coming from if not the Fed?” Essaye asked. He conceded that it was tough to find one sole reason for elevated liquidity supporting broader markets when not coming from the Fed, but did highlight a trend he found when looking at market history.
“Strong stock market rallies almost always occurred in the wake of short-lived spikes in volatility as measured by the VIX, which suggests that a combination of heavily leveraged put-writing activity and/or money pouring into short-volatility strategies after a volatility spike were providing an ‘artificial tailwind’ for the broader stock market indexes, namely the S&P 500, options for which are the critical inputs in calculating the VIX,” he said.
“The reason short-volatility strategies support gains in the stock market are mechanical in nature is because an options or derivatives ‘dealer,’ whether it be a big hedge fund or a wirehouse bank’s ‘spec-desk,’ needs to hedge the short-volatility exposure. And they do that with long equity positions,” Essaye explained.
As per his research, some examples of this behavior that played out was a volatile 2016 into a favorable short-volatility trade in 2017, and more recently, the volatile beginning to 2025 before a favorable short-volatility trade beyond April 2025.
“Without a Fed balance sheet expansion ‘backstop,’ derivatives markets and speculators are largely responsible for the level of market liquidity, which directly influences the magnitude of market moves when headlines are driving markets, two dynamics we’re facing right now. As such, low liquidity, high leverage, and the lack of Fed support leave the risks of high market volatility elevated in early 2026,” Essaye said.
“Such an environment can lead to overstated moves in both directions, which means keeping close tabs on core market fundamentals will be key to getting this likely increasingly noisy market ‘right’ in the months and quarters ahead,” he added.
The stock market has seen a topsy-turvy 2026 so far, and this week has been especially volatile. The S&P 500 is up 1.2% YTD. Here are some popular exchange-traded funds that track the benchmark S&P 500 index: SPDR® S&P 500® ETF Trust (NYSE:SPY), Vanguard S&P 500 ETF (NYSE:VOO), and iShares Core S&P 500 ETF (NYSE:IVV).
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