Overview
Liquidity supporting financial markets in the current cycle is coming less from central bank balance sheet expansion and more from activity inside derivatives markets and among speculative traders, according to Tom Essaye, founder and president of Sevens Report.
Central banks responded to the 2020 COVID-19 shock by injecting large amounts of liquidity into global markets and substantially expanding their balance sheets. The Federal Reserve led those efforts, but since 2022 the U.S. central bank has been reducing the size of its portfolio.
Correlation between the Fed balance sheet and equities - and why it has changed
Essaye recounts an inquiry from a subscriber about the historical relationship between the Fed's balance sheet and the S&P 500. From 2009 through 2022, the S&P 500 typically rose during periods when the Fed's balance sheet was expanding and tended to fall when the balance sheet contracted. That pattern aligns with the expectation that a supportive Fed stance and quantitative easing create an environment of higher market liquidity, while a shrinking balance sheet tends to coincide with episodes of increased volatility and sharper equity declines.
However, Essaye notes that the clear positive correlation that existed up to 2022 has not held since the late-2022 lows on Wall Street. That observation leads to the central question he poses: if liquidity is not coming from the Fed, where is it coming from?
Derivatives, short-volatility strategies and mechanical hedging
Essaye does not attribute the change to a single factor but highlights a recurring pattern in market history: strong stock market rallies often follow short-lived spikes in volatility as measured by the VIX. He interprets that pattern as being consistent with a wave of heavily leveraged put-writing or flows into short-volatility strategies after a volatility spike, which then provide an "artificial tailwind" for major equity indexes such as the S&P 500. Options on the S&P 500 are central inputs for calculating the VIX, which is why VIX dynamics figure prominently in his analysis.
The mechanics are important: when a derivatives market participant - whether a large hedge fund or a bank's speculative desk - takes on short-volatility exposure, that party typically hedges the position by buying underlying equities. Those hedges, in aggregate, can provide meaningful buying pressure in the stock market and thereby support index gains.
Historical examples cited
Essaye identifies specific instances where this dynamic appears to have played out: the volatile period into 2016 followed by a favorable short-volatility trade in 2017, and more recently, a volatile start to 2025 followed by a favorable short-volatility trade beyond April 2025. He uses these episodes to illustrate how derivatives-driven hedging and flows can supply liquidity in the absence of Fed balance sheet expansion.
Implications for market structure and near-term risk
According to Essaye, without a Fed balance sheet expansion acting as a backstop, derivatives markets and speculators are largely responsible for the prevailing level of market liquidity. That relationship, he argues, directly affects the magnitude of market moves when headline risk is driving trading - dynamics that he says are relevant today.
He warns that the combination of low liquidity, high leverage, and the lack of Fed support elevates the risk of pronounced market volatility in early 2026. Such an environment, he says, can produce overstated moves in both directions. The implication is that close attention to core market fundamentals will be necessary to navigate what he expects to be an increasingly noisy market over the coming months and quarters.
Market snapshot
The stock market has experienced a volatile 2026 to date. The S&P 500 is up 1.2% year-to-date. Popular exchange-traded funds that track the S&P 500 include SPDR S&P 500 ETF Trust (NYSE:SPY), Vanguard S&P 500 ETF (NYSE:VOO), and iShares Core S&P 500 ETF (NYSE:IVV).
Summary, key points and risks
Summary - Tom Essaye contends that recent market liquidity is being supplied primarily by derivatives markets and speculative short-volatility strategies rather than by expansion of the Fed's balance sheet. The historical correlation between balance sheet growth and equity market gains has weakened since late 2022, and hedging flows linked to options activity have provided buying pressure that supported rallies.
- Key point 1 - The Federal Reserve expanded liquidity during the COVID-19 shock and increased its balance sheet through 2022; since 2022 the Fed has been shrinking its balance sheet.
- Key point 2 - Historically, the S&P 500 rose when the Fed's balance sheet expanded and fell when it contracted from 2009 through 2022; that correlation has not held since the late-2022 lows.
- Key point 3 - Derivatives-driven hedging - particularly after VIX spikes - can force dealers to buy equities to hedge short-volatility exposure, supplying liquidity that supports market rallies.
- Risk 1 - Low liquidity combined with high leverage, in the absence of Fed balance sheet support, raises the chance of elevated volatility in early 2026; this impacts equity markets most directly but can spill into related credit and derivatives markets.
- Risk 2 - Reliance on short-volatility strategies to provide market liquidity means price moves can be overstated in both directions, increasing trading noise and complicating fundamental analysis for market participants.
Note - The analysis reflects the observations and conclusions attributed to Tom Essaye in his research note; it does not introduce additional causal claims beyond those presented in that note.