The Problem Isn't the Models, It's the Economy Itself

It was about a year ago when I was busy trying to work out and describe how the intersection of the global dollar short, through eurodollars, and the Federal Reserve's very clumsy attempt at trying to carefully back its way into an eventual (and very much predetermined) exit from years of "emergency" intrusions might lead where they never expected. At the time, the yield curve was moving quite disorderly toward interest rates everyone was convinced were harmful. How times have changed, as this week the very clear disorder is now in the opposite direction, but curiously validating in many ways that original position I held during the 2013 mess.

To say that Wednesday's trading was astounding might actually leave out too much. Right at the open, the treasury market was imbalanced in bids that took the 10-year note yield down nearly 30 bps, in what would have been the largest move since 2009 (surpassing all those dark days in 2011 when Europe held itself barely on the precipice). However, that was the initial action and volatility, something very rare these past few years under the cloaking agents of QE3 and QE4, reigned as the final settling of the 10-year was closer to the previous close than the bottom of the morning. The 10s were not alone in their gyrations, as the entire treasury curve was bid and then offered in similar violent fashion.

Anyone following the inner workings of global finance in 2014 would not be so surprised by this. Liquidity as apparent in a number of functions and segments has been far less than ideal, to the point that serious strain has cropped up here and there in what should really have been nothing much at all. We are conditioned to think of illiquidity as something out of a selling impulse, but in the world of collateral and internal finance there are usually more angles than theoretically apparent.

To that end, it seems like Wednesday was a breaking point of sorts in that the huge imbalance of bids in UST's were very likely due to collateral calls. Overextended positions had been under some severe strain, all dating back to early July when the "dollar" shifted to disorder.

The most inoperable part of financial commentary is how it treats the dollar, the rising dollar in particular. There are certainly times when a rising dollar might mean a positive stretch, but those are mostly in the deep past with little bearing on the current construction. The world is, in summary, short of "dollars", perpetually so, to the point that nobody knows by how much or in what shape. Banks all over the world essentially lend dollars they don't have, but are able to do so because the transformed eurodollar market married wholesale finance with near-limitless ledger and balance sheet potential. As long as you can find easy and cheap repo or some derivative form of short-term financing, this global dollar short makes no difference; in fact it is the highest form of fractional lending, extending the normal carry trade as far as possible on the borrowing side.

In 2013, that was very clear in not just credit markets but global currency markets that were beyond flustered by the changing character of eurodollar availability. Higher interest rates, as they relate to wholesale global finance, are indicative of nothing but "tightening" finance in that rollover area; so too is the "price" of the dollar then. Like any short squeeze, the price will rise in disorderly fashion when the squeeze passes some point. Leverage then has to come in and that leads to all manner of disorderly selling if liquidity is less than ideal. So at the same time the Indian rupee and Brazilian real nearly crash in 2013, so too does US MBS trading.

From July 2014, however, there is a lot that is different in what occurred, but the same sorts of results. Interest rates all along the treasury curve have been falling; the eurodollar curve too, at least from 2017 and out. That has meant a very bearish signal on global "money" as the time premium, the essential element of risk in lending or using currency over time, declines by more than a little. Inside of 2017 in eurodollars, the opposite was taking place as "market" participants have been trying to gauge how and when the short-term wholesale markets might finally be freed from ZIRP.

So in both cases, 2013 and now in 2014, the "dollar" was rising denoting a growing shortage of finance for rolling forward the global dollar short, thus crashing numerous currencies and unsettling the bond market here and globally. Yet interest rates were rising then but falling now, indicating a very complex set of circumstances not easily resolved in neat and tidy expression of order - in the interim between these episodes, "somehow" the US treasury curve has found its way into a very bearish flattening trend.

If you actually trace that curve flattening, and this applies to every major curve segment, it all points to the same moment - November 20, 2013. To this day I have no idea what went on then, only that I am absolutely positive that something did. Start with swap spreads, as both the 5-year and 10-year spreads jerked into the negative on that day. Given the likely positioning of global dealers in swaps, who are the same entities counted on for providing liquidity, it doesn't take too far of a leap to see that the curve steepening (accompanying rising interest rates last year) was just too much to bear; somebody had a lot of risk to lay off with very few apparent takers.

November 20 was also noteworthy in that the Open Market Desk suddenly and for no given reason began to buy the 9- and 10-year treasury segments with seeming earnest specifically where it had stayed close to the belly of the curve in almost every instance prior (the initial schedule called only for purchases in the 2021-23 range on two occasions in later November, and then weekly in December). Whether that played a role in redirecting the treasury curve will never fully be established to anyone's satisfaction, but you cannot deny the extraordinary nature of the coincidence. How is that the POMO buying program changes its focus (without appearing to do so) at the very moment the US treasury curve shifts to a bearish flattening trend that has now lasted nearly 11 months and has taken calendar spreads to lows not seen since the darkest days of 2009?

If that was indeed the case, and this cannot be labeled as anything but speculation on my part, and that the swap positions and POMO change all relate to the same process, then it may just go down in history (if someone inside ever writes a book about it) as an all-time great backfire. For in that moment on that day, or whatever took place close to it, there must have been a sense that this all could be controlled and that order can be determined by central intervention.

For all the certainty by which economists and monetary policymakers assert, they have no, actually can never, handle that the smallest changes in a complex system can lead to drastically altered results. There are, of course, other factors that play a very big role in setting conditions and trends, but that is precisely the point.

I have written before about Dr. Edward Lorenz' "mistake" in discovering the basis for what became known as chaos theory. He was actually preceded by a famous 19th century mathematician, J. Henri Poincaré. Poincaré was an absolute genius, a mathematical mind that may be unrivaled in history. To that point in the 1800's, the physical world was seemingly ruled by deterministic physics developed by another genius, Isaac Newton. However, Newtonian physics, or, more precisely, the math by which it all seemingly worked, was only a two-equation system - the very edge of what Newton's differential calculus would allow. There were two pre-eminent "bodies" in astrophysics, but naturally people began to wonder how it might all work if a third were introduced.

The Three Body Problem was never actually solved, and it was Poincaré that won a prestigious prize in proving that it could never be. What he found was that Newton's math was limited to "closed form" solutions, those that work elegantly in their own right but fall apart upon the additional complexity of the third body. So where equations for two bodies can give a measure of deterministic certainty in the physical world as we see it, three bodies changes the character of the math from continuous to discrete.

Poincaré found that in trying to draw the orbits of this three-body system he could never do it; worse, though, was that when he changed the starting point of any of the bodies by even a small amount, the end result of the orbit was totally different. He wrote, "It may happen that small differences in the initial positions may lead to enormous differences in the final phenomena. Prediction becomes impossible." In other words, the system is very sensitive to initial conditions, one of the primary facets of complex systems and chaos theory, as Dr. Lorenz would finally bring out decades after Poincaré died.

Just before he died, Poincaré was a member of the first Solvay conference in October and November 1911. Ernest Solvay, a wealthy Belgian chemist, gathered the most important scientific minds together to hash out some of the biggest theoretical problems in physics, with that first conference accomplishing very much toward what is now known as quantum physics.

In between that first Solvay Conference and the fifth, the more famous of the bunch, held in 1927, the state of quantum physics had split into very different places. There were those like Albert Einstein and Erwin Schrödinger who believed that the world was the world, and that quantum physics must have some relation to our physical experience (Schrödinger's cat "paradox" being a response to the statistics end). On the other side was Niels Bohr and his former assistant Werner Heisenberg, who had formulated his "uncertainty principle" in February 1927.

For Bohr and Heisenberg, the universe existed independent of our participation, and that our act of observation caused existence (the collapsed state). Bohr stated that particles had no "independent reality in the ordinary physical sense." Einstein was assured that was not the case, challenging the idea that statistics were descriptive of existence and that probabilities governed everything. What became known as the Copenhagen Interpretation follows along those lines, the Bohr/Heisenberg format, that the wave function of matter as inseparable from the particle function is esoteric and remote from our conception of reality. In that respect, the wave is just a mathematical expression for calculating specific properties, and not anything "real."

That became the dominant strain in quantum physics despite the objections of Einstein and Schrödinger, who continued to insist that a physicist's job was not to live in a world of probabilities, remaining intentionally remote from actual experience. For them, the fact that the wave function was nothing more than a theoretical concept of math meant that quantum physics was incomplete, and that it needed to bridge the divide between statistics and human experience and observation. As he wrote to Bohr directly, "What we call science has the sole purpose of determining what is," something that Heisenberg and Bohr were unconcerned with.

Einstein also wrote to Schrödinger not long before he died, almost three decades after the fifth Solvay Conference,

"You are the only contemporary physicist, besides Laue, who sees that one cannot get around the assumption of reality - if only one is honest. Most of them simply do not see what sort of risky game they are playing with reality - reality as something independent of what is experimentally established."

That quote, for me, contains the problem of modern economics that has been so divorced from reality. The idea that statistics is enough to gain such control over money and economy is to be devoid of real experience - to make everyone the agent of a variable in an equation that, as Poincaré found in the nineteenth century, can only be limited. The real world is infinite in its possibilities, yet the math is predetermined into a closed loop of statistical inference that doesn't even hold potential as the Copenhagen Interpretation did. In other words, modern economics has detached itself from reality without any good reason for doing so.

The certainty by which the modern orthodox economist operates is as illusory as Newtonian physics - it works only under the narrowest set of conditions, which does not describe complex reality. Furthermore, the "discipline" of economics has taken upon itself not to move closer to actuality, but to find and model, mathematically, the very narrowest sense where those conclusions might actually fit.

The perfect example of this reductionism is Japan's experience with QQE. Rather than seeing a complex set of circumstances that would make for some very difficult solutions (including the very real possibility of a solution that the Bank of Japan should just get the hell out of the way), instead Japanese malaise that now extends an extraordinary and astounding quarter of a century has been reduced to nothing but "deflation." In the simple statistics of orthodox monetarism then, all that must be done to solve the equation is to flip the sign in front of the variable for consumer prices.

Now a year and a half later, the Japanese economy has done exactly that and is far worse for having done it. They are staring at the reality of not just a recession in progress, but potentially a very bad one, having already destroyed the merchandise surplus that represented all the actual wealth created since the country's rise from the ashes of World War II. It was not enough that QQE failed in its primary transformation, that flipping to "inflation" would be a positive catalyst, they had to sacrifice the trade situation along the way (a fact that was wholly unexpected in the narrow view of modeled expectations).

As such certainty in economics continues to fail with actual economic experience, we should expect nothing like the Solvay Conference achievements since there is nothing like scientific discipline to the endeavor. The practitioners of this field are all ideologically committed to that course regardless of results; they have totally upended "science" in that their loyalty is absolute to the math rather than experience. In that regard, ideological purity is all that matters, everyone else is a heretic to be disowned at the slightest tendency toward free thought and observation.

Anyone with some familiarity with the current "debate" about secular stagnation can see it as exactly all of this. None of the models predicted where the economic potential of a system might be degraded by "some" unknown factor. Therefore, the problem is not with the models but rather with the economy - all that matters is that econometrics is preserved, even if it means devolving theory into convoluted nonsense. After all, the entire basis for this certainty was the very Keynesian idea that central planners could "fill in the troughs without shaving off the peaks," and do so with the blunt and corrosive instrument of debt (the monetarist strain). Suddenly the peaks are shaved but rather than revisit that original premise it gains even more rigid preservation.

The most radical idea of all, the one totally opposed to the current certainty of economics, is that it doesn't exist. Furthermore, the implication of that is decentralization, as in the whole strain and tendency toward econometrics and certainty has been one that "markets" are in comparison too deficient. By extension of the repeated and persistent divergence of statistical modeling from reality and experience, the logical conclusion would be to disallow that main premise. Since we live in a complex system, very sensitive to initial conditions, it stands to reason that the ability to incorporate near-limitless data in real time (true markets) would continue to be superior to what amounts to the modern incarnation of Newtonian limitations. To ignore that would be like trying to gain control over the yield curve and having it collapse in the opposite direction in total defiance of everything the math calculated as an expectation.