Market Volatility Surges as Liquidity Drops and Fed Reduces Reserves

Market dynamics have shifted significantly in recent weeks, with equity financing costs declining and liquidity levels dropping on the stock market today. The Federal Reserve has reduced reserve balances, leading to higher overnight funding costs and increased stock market volatility.

Equity financing costs, as indicated by the BTIC S&P 500 Total Return Futures, have started to decrease, suggesting a reduction in leverage. This trend is accompanied by a significant reduction in liquidity, with reserve balances held at the Fed declining to around $2.98 trillion as of October 1. The impact of this reduced liquidity is evident in the higher overnight funding costs, with the Secured Overnight Financing Rate (SOFR) trading 11 basis points above the Fed's effective funds rate, and a 10-day moving average trending higher.

Market volatility has also increased, with the 3-month realized volatility dropping to 8.3%, a level last seen in January 2020, October 2018, and December 2017. The VIX, a key indicator of stock market volatility and risk, has climbed to 16.6 from 14.8. Market participants are hedging against downside risk, utilizing low index level implied volatility to do so, as the S&P 500 has moved higher. Correlations are very low, with the 1-month implied correlation index standing at just 9, a level seen only in July 2024. This low correlation, coupled with reduced liquidity, has introduced significantly more volatility in the stock market.

The S&P 500 dispersion index reached 34.39 by the end of the day on Friday, October 3, one of the highest levels since 2015, indicating high dispersion in the stock market. Implied volatility levels for the stocks within the S&P 500 have climbed significantly, with the S&P 500 constituent implied volatility index climbing from 31 to 38.2 since September 12.

The reduction in liquidity and increase in stock market volatility are significant developments that could impact stock market dynamics in the coming weeks. Market participants are advised to monitor these trends closely and adjust their strategies accordingly. The Federal Reserve's actions will also be closely watched to see if they respond to these changes on Google Finance and Yahoo Finance.