An Easy Way For You To Understand Complex Markets 2
Finally, we have come to the deepest part of the Iceberg – Paradigm.
Paradigm is very special because it exists purely on an ideological level, but manifests itself physically throughout all the layers of the Iceberg above it.
Capitalism, for example, is an idea of how economies should be structured.
Societies that begin from this starting point then create institutions and entities that are required for a capitalistic economy to function. These are the components in the system, the Systems structure.
Once the components are up and running, their interactions over time coalesce into Patterns of behavior. These patterns then become the context behind observable outcomes, or Events.
As you can see, everything starts from an idea.
To see how this transpires in markets, replace “Capitalism” with “the Fed” in the above paragraph.
Markets believe the Fed is in control of all things economic and financial. Their entire worldview is structured around the Fed sitting in the center, that’s their current paradigm.
The result of markets holding such a paradigm is that everything is explained away using the Fed. For each level of the Iceberg:
Events: “Markets are up today because the Fed cut its target Fed Funds Rate by 25 bps”. This is a headline that should be familiar to all who read the financial media.
A reductive statement expressed in linear cause-and-effect terms used to explain real time happenings in the markets – this is exactly what the first, and only, visible layer of the Iceberg represents.
Patterns of behavior (market trends): “Treasury yields continue their downward trend as the Fed resumes QE” Another headline that should be familiar.
US yields have been moving lower for slightly longer than three decades now, with the Fed’s QE programs taking long term yields closer and closer to zero, and short end yields bouncing around zero/negative.
For whatever reason(s), USTs have been well bid for a very long time. But, because of the Fed-centric paradigm, the downtrend is, and has been attributed to Fed policy (and will continue to be until the paradigm changes).
System structure: What are the components of a Fed-centric financial system? A macro view of the system would include the Fed, banking system, capital markets, and the economy.
Interestingly, the diagram immediately shows that the Fed-centric view isn’t actually Fed-centric, simply because the Fed can only affect the economy and capital markets* through the banking system.
For instance, the Fed-centric view holds to the idea of Fractional Reserve Banking, which works in theory but not in practice. Instead, money is created from new loans made by banks, which is congruent with what we see in the diagram, where the banking system sits in the middle, not the Fed.
This precisely illustrates the power of Paradigm – it doesn’t matter if a theory works or not, it matters that people think it does.
It doesn’t matter if the Fed sits in the middle of the system or not, it matters that people believe it does. Every thought, line of reasoning, and inquiry into what happens in markets is thereafter erroneously built upon that belief.
Given how powerful beliefs are, and how deeply they influence our thought processes and behavior, it isn’t surprising that they are extremely difficult to change.
Similarly, Paradigm, at the deepest point of the iceberg, illustrates that it is the part of complex systems that are most difficult to change. Which also means that when it does change, the effects are profound, explosive, and more often than not unforgettable.
Which begs the question – What happens when the market’s paradigm changes?
*This is not always the case. The Fed can choose to purchase whatever securities it wants from the capital markets, although most of the time they choose to do so through the Primary Dealer network , whose members are all big Wall Street banks.
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