Goldman Sachs: Liquidity Backdrop Adds Fuel To The Vol Spike

Goldman Sachs note that "the initial portion of the rise in interest rate volatility was fairly orderly, with indications that market liquidity had remained relatively stable despite the sizable intraday swings. That backdrop seemed to shift materially on Thursday, however, as price action was somewhat less well-behaved, particularly in the aftermath of the 7-Year auction - indications from top of book market depth suggested a sharper deterioration in liquidity. While implied vol is somewhat above the last month's realized volatility, we don't think this premium is necessarily misplaced. We note that although recent liquidity has deteriorated, on a variety of metrics it remains considerably better than last March. However, to the extent that weak end-user demand (as was seen in Thursday's auction) and selling pressure leads to pressure on dealer balance sheets, we could see a continued drop off. Given this, and uncertainty about central banks' response thresholds, the potential for future disorderly price action remains, leaving implied vols on shorter expiry options well-supported. Our view on the latter is that while continued challenges in market functioning could elicit a Fed response, the bar for action is likely to be high."