Two weeks ago, Chinese stock futures traded in Hong Kong flash crashed. Between 2:14pm and 2:16pm local time on May 17, the Hang Seng China Enterprises Index suddenly liquidated due to an intense burst of sell orders that crashed through the whole of the futures market depth. At the start, the index was trading at around +1% but fell to as low as -1.5%, for a 2.5% swing in a matter of seconds.

“The market reacted like a startled cat,” Andrew Sullivan, managing director for sales trading at Haitong International Securities Group in Hong Kong, said by e-mail. “There is a lack of clarity on what is happening in China.”

It was an alarming re-occurrence since Chinese stocks though they had been recovering from the huge selloff to start the year (after last summer’s even bigger drop) are still precariously situated given an unending list of pressure points. Thus, in many ways the “irregular” trading today shouldn’t have been that surprising, either. This time, the Hang Seng Enterprises Index dropped 12.5% in seconds (from +2.5% to 10% limit down), recovering all losses within a minute of trading.

“Liquidity in the market is really thin at the moment,” Fang Shisheng, Shanghai-based vice general manager at Orient Securities Futures Co., said by phone. “So the market will very likely see big swings if a big order comes in.”

There it is; the big factor in everything in either direction. If liquidity seems plentiful, markets rise as if there weren’t a care in the world. If it is erased, then the “irregular” becomes increasingly anticipated. Liquidity isn’t liquidation, but they aren’t that far removed especially under far less than robust circumstances. In China, the warning only grows louder.

ABOOK May 2016 CNY3 3m

It may just be coincidence these flash crashes taking place after the passing of the second 3-month window, though I strongly doubt it. The shift in CNY indicates the increased (“dollar”) pressure from maturity of prior PBOC efforts that had created the false sense of liquidity that buoyed global markets in the first place. As liquidity tightens up or disappears altogether, all kinds of markets start acting “irregularly.”

But it doesn’t just end at the unusual trading behavior in limited, discrete circumstances. Having been through two of these completed liquidation waves, some “investors” (and even media) are starting to catch on.

Short interest in one of the largest Hong Kong exchange-traded funds tracking domestic Chinese stocks has surged fivefold this month to its highest level in a year, according to data compiled by Markit and Bloomberg. The last time bearish bets were so elevated, such pessimism proved well-founded as China’s bull market turned into a $5 trillion rout.

 

While trading in the Shanghai Composite Index became subdued this month amid suspected state intervention, pessimists are betting that equities face renewed selling amid a slumping yuan. The Chinese currency is heading for its biggest monthly loss since last year’s devaluation as the nation’s economic outlook worsens and the Federal Reserve prepares to raise borrowing costs, driving a rally in the dollar.

Setting aside the obligatory unearned deference to the Federal Reserve’s somehow preserved mainstream status, even if you don’t actually know why CNY is falling you don’t really need to in order to figure out what might happen when it does – and does so at an increasing rate. It’s a really simple correlation; CNY down = bad.

ABOOK May 2016 CNY3

The propagation of “bad” also seems somewhat predictable in effect if not so exactly in time. It starts small with “anomalies” that gain attention and then acceptance. This kind of “blast wave” then travels outward into other markets, into seemingly unrelated assets such as those on global exchanges; the pathology or explosion chain all following the “dollar.” If we assume that the “ticking clock” striking zero back in either mid-April or mid-May was detonation, so to speak, we would expect to find increasing damage as the illiquidity effects move outward. So far, that does seem to be the case.

What is more difficult to determine or predict is how long it might take the “blast” in China to radiate out into the general marketplace. It seems as if there should perhaps be more immediate reaction to the unfolding disorder, but we live in an era where “investing” is an unnecessarily loose idea especially when Janet Yellen and her cohorts around the world continue to be revered and respected no matter how many times they so thoroughly disprove themselves.

Chinese shares posted their biggest daily gain in three months on Tuesday on growing expectations U.S. market index provider MSCI could add mainland stocks to its emerging market benchmark for the first time.

In other words, Chinese stocks were up before and after the flash crash because of speculation not that China is in full rebound or that “stimulus” was finally, finally appearing to actually work but rather because of index adjustment. I am being a little too harsh in highlighting the absurdity of a single trading day, but these are very much absurd times. It leaves us asking how long it can continue before the illiquidity wave really starts to be disruptive.

ABOOK May 2016 CNY3 US Stocks

In the past two episodes, it was truly a delayed reaction each time; amounting to several months in the first, and almost two months in the second. CNY was trading at nearly 6.31when it turned in early November, but had fallen to just about 6.50 at the end of December before US stocks were impacted. In August, the “devaluation” occurred all at once condensing many months of prior buildup – and still it was two weeks afterward when US stocks liquidated (also all at once, suggesting a fractal reflection that deserves greater consideration at a later date).

From all of that, we can reasonably assume that the pressure is building with CNY’s latest inflection the point of “detonation.” The warnings are all there and increasing in the form of illiquidity. We just don’t know exactly at what point CNY becomes globally disruptive, only that there is a good chance we are for a third time about to find out.