Why Is 2nd Order Thinking Important In Trading & Investing?
Figuring out the range of second order consequences is especially pertinent in financial markets, whose complexity ensures that ripple effects are felt in the most unexpected ways and places.
This means that instead of blindly following mainstream narratives and their linear A leads to B leads to C logic, one must be cognizant of how the markets actually work.
This means being aware of traders/investors Paradigm, as well as how they are reacting to mainstream narratives.
If you can find a mismatch between how markets are “pricing in” narratives in relation to market trends and structures, you may have found a trading opportunity.
For example, the predominant trend of UST yields is lower, and has been for slightly more than 30 years. That’s a very long, very well-established trend.
The “boom times” narrative is calling for rampant inflation sometime soon, and the market has pushed up long dated UST yields as a result.
However, in the context of a 30 year down trend, the rally in UST yields is pitifully small.
Furthermore, knowing how the system is actually structured, that is, not Fed centric, will help you question the efficacy of central bank policy. This in turn will make it much easier for you to accept that QE does not work, and that most market participants are operating under gross misperceptions.
Understanding all of this will help you to see price action in a new light, namely:
Everyone believes that Fed/government intervention (Action) will lead to inflation and has positioned themselves accordingly by selling USTs, driving yields higher (Consequence). But long term market trends and how the system actually works imply otherwise. Doesn’t this entail that the UST selloff is, more likely than not, an opportunity to go long Treasuries (Second order consequence)?
Put another way, the consequence of the consequence of market misperceptions is a trading opportunity!
From a broader, and arguably more important perspective, policymakers’ over eagerness to act leads to severe unintended consequences.
First of all, they are acting without fully understanding the complexity of the systems that they are intervening in. Fiscal stimulus does not work in the way textbooks say they do, and the Fed, for some reason, is intent on stuffing the banking system with more reserves that cannot be lent out.
Secondly, their actions come with little consideration of second order effects. Their justification is often “it is better than not doing anything at all”, but when QE has not created the “good kind” of inflation it is supposed to create, then what are the benefits of the policy?
At least fiscal stimulus puts money in the pocket of people who need help purchasing essentials and paying their bills, even if it cannot lead to sustained growth and the “good kind” of inflation.
Instead, slightly more than a decade of QE in the States has exacerbated inequality. It has also simultaneously increased the likelihood of future systemic crises by removing large amounts of USTs from the financial system – USTs that the global repo market desperately needs for use as collateral.
Removing something that the system needs (USTs), and replacing it with something they don’t (Reserves), thereby increasing the likelihood of future instability in markets… isn’t this the epitome of failing to consider second order consequences?
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