Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?”Was the question Edward Lorenz posed as he dove into his exploration of Chaos Theory.
It was his way of stating that a tiny, inobservable change in input can lead to a massive, very observable change in output. This occurs in nonlinear (aka chaotic) systems where intricate interdependencies between components of the system take little wing-flaps and amplify them exponentially through a series of feedback loops.
The same thing happens in financial markets, where changes in one part of the world can lead to very drastic effects across global capital markets, Covid-19 being the case in point. These effects in turn force policy makers into responding, which creates new sets of consequences, etc. We are therefore living with a set of consequences which stretch back and forward through time, a reality which is simply too complex for the human mind to comprehend.
Our natural response is to reduce this complexity into smaller, more understandable parts, but doing so makes us blind to just how far reaching the consequences of our actions are. Ironically, by ignoring complexity, we become stuck inside a complex feedback loop of our own making, where each new action we take keeps us locked into situations with no good options.
We hope that as readers make their way through this Collection, they can get a sense of the nonlinear nature of markets, and an appreciation of the importance of thinking through the lens of complexity rather than simplicity.
A stronger USD wreaks havoc in a few ways.
Firstly, it increases the amount of money owed by EMs who borrowed in USDs as opposed to their own local currency. This is simply due to currency effects, for example:
Here we have a company which owes USD 1000, but earns revenues in a different currency, XYZ.
Therefore, the company has to exchange XYZ into USD in order to repay its debt, which exposes it to changes in the USD/XYZ rate.
When USD/XYZ strengthens from 1 to 2, this doubles the amount owed in terms of XYZ, which means that it now has to find a way to make up the shortfall.
Unfortunately, times where the USD strengthens dramatically tend to also be times where USD reliant foreign economies also face economic headwinds.
As such, a strengthening USD leaves the company in a terrible position. It now owes more in terms of XYZ, even as the economy contracts and reduces its ability to generate the extra revenue needed to make up the XYZ 1000 shortfall.
On top of this, businesses that have to pay their suppliers in USDs now find that their costs have increased by as much as the dollar has strengthened against the local currency.
This has a major economic impact as firms have to find some way to lower their costs – most likely by laying off workers. These layoffs in turn send a deflationary impulse rippling through the economy, as people start conserving cash and cutting spending in the face of mounting job and income insecurity.
Furthermore, import costs for all goods and services priced in USD, commodities being a prime and very pertinent example, will have skyrocketed. Supply cuts made by producers in the face of falling demand will exacerbate this situation, as observed in oil and copper during March/April 2020.
The higher cost of imports now creates an inflationary impulse in the economy, but not the “good kind” of inflation.
In fact, this is the worst possible kind of inflation to have at a moment when the economy is also contracting and thus experiencing deflationary forces.
Because the higher prices only serve to further increase the cost burdens of already struggling businesses. More layoffs are in order, which compounds already existing deflationary impulses and further reduces the willingness of EM creditors’ to extend any sort of credit for fear of loss.
And so the negative feedback loop perpetuates itself until all markets involved, USD, interest rates, labor, etc, find some kind of tenuous balance from which a potential recovery might arise.
Note that what started out as a USD shortage in the global Eurodollar market has now morphed into a massive economic crisis in the countries which cannot get USDs. At the height of the crisis, this would include pretty much every country other than the United States.
The sequence of events and their interconnectivity described in this 4 part article are not a hypothetical, reductive and overly linear forecast of events that might happen.
They have already happened, twice in very big ways in 2008 and 2020, with a few smaller ones along the way, causing massive economic damage.
Even so, those in charge continue to not only prescribe policies that undermine more than they help, they also continue to misdiagnose the problem!
Imagine that you are out taking a relaxing walk along a picturesque trail. You find yourself enjoying the natural beauty of your surroundings and the crispness of the air. Then, out of nowhere, you see a small fence in the middle of the trail.
What do you do?
The fence doesn’t obstruct the sides, so you can simply walk around it. As far as you can tell, it seems that all the fence is doing is being an unnecessary obstruction.
Perhaps the best thing to do would be for you to remove it? Or would the better course of action be to just leave it as it is?
As trivial as this problem sounds, it is actually a famous example thought of by G.K Chesterton. Named Chesterton’s fence after the writer and polymath, the example serves to highlight the importance of, and more often than not also the lack of, second order thinking.
What is second order thinking?
Quite simply, it is thinking about the consequences of the consequences of one’s actions.
Envisioning the immediate consequences of one’s actions (first order thinking) is a simple thing that the vast majority of human beings manage without much effort.
It’s a simple if-then thought process after all: if I take down this fence, then I can walk down the middle of the path.
Considering the consequences of those consequences though, is a much more difficult endeavor.
What happens if I take down this fence, and I can walk down the middle of the path? If your mind is blanking trying to conceive of possible answers to this question, it just highlights how counterintuitive it is for our minds to think in this way.
Perhaps thinking about it from another perspective will help. Instead of thinking in terms of “consequences of consequences”, try thinking of it like this: what if the fence was put up for some reason?
As difficult as it may be for you to think of what that reason may be, given how random its placement is, that does not mean that the fence was just placed there without one.
In this case, removing it could have serious repercussions – except you have no idea what those repercussions are because you do not know why the fence was put there in the first place.
Chesterton’s recommended path of action is to leave the fence be, and to walk away to think about what possible reasons could exist for the fence to be there. More broadly, he is trying to make the point that frequently, we come across “things” that make no sense to us and feel tempted to just do away with them.
However, more often than not, these “things” were put in place for reasons that we are not aware of, and intervening in them can lead to large, unintended consequences.
In other words, if you remove the fence, you would be able to walk down the middle, but in doing so you could be causing harm to someone, or something else. Coming to the realization that the consequences of your actions in turn have their own consequences is just the beginning, however.
After that comes the essence of second order thinking (and the much more difficult part), trying to figure out the range of second order consequences.
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?