Molotov Cocktails, Volatility, Stability, And Faux Liquidity

By Peter Tchir of Academy Securities

Markets have experienced high levels of volatility over the past few weeks. From silver, to software stocks, to cryptocurrency, we have seen violent price swings on almost a daily basis. We have political risks, geopolitical risks, as well as the implications of a rapidly evolving technological shift. We touched on Non-Standard Deviations last week, and are going to expand on that today.

We will attempt to examine the bigger picture of the potential volatility from transitioning from one world economic order to another. We also highlight how liquidity, or in our view, the lack of a true depth of liquidity, plays in this world.

Molotov Cocktails

Gasoline, in a tank (or a bottle) at room temperature, is stable. Apply a catalyst (a rag lit on fire) and we enter the “volatility” phase. An explosive, hot, and unpredictable phase.

Once the heat has dissipated, we are left with CO2 and H2O (carbon dioxide and water). Both are very stable. And in our example, there is some broken glass from the bottle, which isn’t as stable as when it was in the form of a bottle, but it isn’t doing much of anything.

There are all sorts of examples of these transitions from one form of stability to another form of stability, with some sort of volatility in between. A rock near the edge of a cliff that is pushed over. Nuclear fission may also fit. I think we could even apply the word entropy here, but we went with the Molotov Cocktail since it implies an intentional act of destruction.

The Global Economic System

We had settled into a multilateral, trade-based global economic system. The complexity of supply chains grew over time. Dependent on trade, but optimized by companies to serve their purpose.

Companies grew and became increasingly global in their scope. For many, the concept of national boundaries was vastly diminished.

While global tensions existed, the big, richer nations were all free to trade. Many resource rich nations prospered (or at least their leaders did).

Then China, quietly, and barely noticed by anyone, tossed out the first Molotov Cocktail. That may sound provocative (and may even be provocative), but it is a good place to start this discussion. It fits with our work under Trump 1.0, when so many were lamenting that the U.S. was “starting” a trade war, and we argued that we had been in a trade war for years, if not decades, and were “finally” firing a shot.

In the past decades, China has quietly, though overtly:

• Taken Intellectual Property. There is no question that the IP theft occurred. We can argue about the size of the theft, but it did occur. This was as much on “us” for letting it go on and continuing to believe that we could trade “normally” with China.
• Cornered the Market on Processed and Refined Rare Earths and Critical Minerals. This is largely on “us.” We didn’t want the “dirty” aspects of this industry in our own backyards. NIMBY (Not In My Backyard) played a key role in allowing this development to occur. It was almost as though the “lack of greenness” was “hidden” if “we” let China do all the “dirty” work. Clearly the latest round of trade negotiations (and viable threats from China) have highlighted this.
• Subsidies and unfair trade practices. Long after the Chinese economy developed into a high- powered, industrialized, and sophisticated manufacturing hub, the world gave it many trade advantages (on “us”). The flipside was that China was very good at subsidizing businesses by keeping prices of certain things at a level where China could then squeeze competitors out of the market. That was largely on “China” but “we” were more enamored with the cheaper prices than we were concerned about the repercussions of being de-industrialized. Heck, less industry (and carbon) was a “feature” not a “bug.”

Without a doubt, this administration has tossed a Molotov Cocktail, or two (or even a hundred), and this is reshaping the global economic system.

The administration’s policies have set off a chain reaction that is re-shaping the global economy, but much of it is in response to (or in an effort to change the path of) China, which had been steering for the world.

A ProSec System Can Be Stable As Well

As you know (and might be sick of hearing about), we think a ProSec Economy is the direction we are headed. That production for security and resiliency will dominate policy for governments (across the globe), corporations, and asset managers. We could also describe this as a “Me First” or “Me Mostly First” world order, but I think that has more negative connotations than it really should have.

In this ProSec world countries will:

• Produce a significant “amount” of “things” they NEED domestically. There will be levels of “NEED” that apply. Just like humans need air more than water, and in turn, need water more than food to live, countries will identify their true “NEEDS” and develop businesses around those “things.” “Things” like electricity and energy will be high on that list. For advanced countries, semiconductors will fit into that. The need for processed, refined, and smelted materials will be addressed. Ultimately, healthcare and pharmaceuticals will be prioritized. See ProSec 2026 for a more detailed list of “things.”
• The “amount” that a country can produce domestically will vary by the “thing” that it is producing. Some things, like energy and electricity, can be done fully domestically by almost any advanced country (if they adopt an array of products). Though even there, they may be dependent on others for some level of supply. There will be things that are not economically feasible to produce at scale in some countries. Countries will need to rely on close relationships (by proximity and values) to ensure a robust and resilient economy. One that cannot easily be threatened by another country’s economic policies.
• There is still plenty of scope for “regular” trade. Not every good or product will be important enough for security and resilience to deserve focused efforts from governments (which will play an outsized role at the start of this changing mindset). And even on some “things” there is opportunity to trade – just not at a level where the trading partner can hold you hostage.

It is easy (at least for me) to see a STABLE global economy, based on the principles of ProSec.

It is the TRANSITION from the existing global economic state of play to this increasingly self-sufficient world that will be difficult and volatile.

Faux Liquidity Adding to The Volatility

When you look at your screens and see bids and offers lined up, the market looks quite liquid. There is some truth to it. Never has the market been more liquid for small trades. I would completely agree with that statement.

Having said that, I think we have an “illusion of liquidity” or what I prefer to call Faux Liquidity. When I “imagine” the state of liquidity, here is what I see:

• Hundreds if not thousands of algos (because no human can do this) trying to compete to “scalp” the next tick or fraction of a penny on any trade. Generating bids and offers, trying to capture some portion of the flow profitably.
• Some portion of these algos (the more sophisticated and presumably more profitable ones) rely heavily on correlation. Commodities might be the easiest example of this to see. Different exchanges list different contracts. There are futures, but there are also ETFs. In some cases, you have those who can participate in the “physical” space. They can try to capture what they see as “arbitrages” between markets. As you move to equities and fixed income, the ETFs (and the create/redeem process for those) can play an even larger role. There are all sorts of opportunities to manage risk (and market making) profitably.
• When functioning well, this creates orderly markets that seem incredibly liquid.

The downside is:

• Correlations changing rapidly. Maybe there are margin calls in one specific product on some exchange creating issues. Maybe two things that are generally correlated break apart due to a political announcement, or even a geopolitical event.
• Bid/offer spreads widen as algos drop out. The beauty of thousands of algos chasing a trade means the “inside market” (best bid and offer) can be tight. If algos start losing money (using a function of increased volatility and shifting correlations), they drop out, or don’t chase as aggressively. The bid/offer spread can widen. The size that can be executed on the bid or offer decreases.

That is when we get “air pockets” or what I call “faux liquidity.”

Large trades can no longer be absorbed “easily” by the system, causing prices to lurch to and fro. One minute we are at 100. The next minute at 105. Now the bid/offers start filling back in around 105, but how the heck did we jump from 100 to 105 in seconds? Nobody knows (well, we do, it is the symptom of faux liquidity). Just like the school of fish avoids the shark (images by Grok), only to congregate moments later in another location, the algos adjust to the new level and get back to their job of making small increments while avoiding being eaten by the big move.

I didn’t even mention:

• Passive investing. In a world dominated by the market cap of a handful of stocks, passive looks a lot more like momentum, where inflows (and believe it or not outflows) reinforce momentum as the flow is concentrated in so few names.
• Leveraged ETFs. I have no idea why the SEC approves 2x or 3x leverage on single stocks. I barely understand it on indices, where the path dependent nature takes a toll on the investor, but I cannot begin to understand the need to have it on single stocks. These amplify movements.
• 0DTE. I haven’t forgotten about zero day to expiration options. Daily and weekly options dominate options trading. VIX is increasingly like the DOW – fun for old timers to talk about wistfully, but far less relevant than it once was to market discussions. As what started the day as a far out of the money option becomes an at the money option, the delta hedging needs the market to continue to move in that direction.

We live in a world where the trading instruments and the market making functionality, on any given day, have the risk of amplifying moves, creating bigger gains or losses, than might otherwise have occurred

Bottom Line

We are transitioning:

• From a more global system of trading, to one where countries are more conscious of the risks of being overly dependent on others for “things” that are necessary.
• From a “deterministic” world of compute, to one where probability-based AI is reshaping industries and investment at a record pace.
• A shift from a U.S. dollar denominated world, where dollars were needed to trade, to provide reserves, and could play a prominent role in sanctions and other mechanisms to influence behavior, to a world where the dollar may not be as important.
  • Some would argue that maybe we are even shifting from a “fiat” currency world, to a “digital” or cryptocurrency world. I do think we will see more digitization, but it will be digitization of existing currencies and instruments, more than the dominance of Bitcoin (as an example). I won’t discount the idea out of hand, but it is far from my base case.

The mix of Molotov Cocktails and Faux Liquidity make for a challenging environment.

On the other hand, I think the market is underpricing the number of cuts and timing (I think at least 3 by September with a 50/50 chance that Powell cuts once before his term as Chair is over). I am worried about jobs and the “working” poor. See The Fed, Affordability, and Electricity for more on this view.

Stay warm and enjoy the Super Bowl.