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Re: Mental Models-The Macroeconomic Pond & The Big Chop.
This is a thread about how I'm thinking about the current macro setup.
I’ve been thinking a lot about the low signal:noise ratio in the market lately.
Imagine a circular pond with a perfectly still, glassy surface where you can see a perfect reflection. That was the macroeconomic environment in 2021: every asset class under the sun rallying without a care in the world because of the Liquidity Lottery.
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Enter Kid Kaos — that rambunctious, restless kid who can’t resist shattering the calm by hurling a large rock right in the middle of that pond. “Kid Kaos” is the personification of the source of Inflation, which is apropos because of the economic entropy he sows.
That initial big splash in the center of the pond symbolizes the COVID-induced supply shocks that made big waves around the epicenter of disturbance, but to oblivious observers at the periphery of the pond it looked localized and transitory.
Alas, the resulting ripples kept radiating out in ever-widening concentric circles as the effects of Inflation reached broader and broader markets: first Oil and Gas markets, then derivative markets like fertilizer, food, and petrochemicals, then consumer goods and services more generally, and finally wages and shelter.
The amplitude of these initial Inflationary Ripples was large due to the calm initial conditions and the absence of countervailing forces — similar to a world and economy inured to impossibly perfect conditions resulting from the Endless Liquidity Lottery. Unfortunately, it’s these perfectly picturesque glassy tableaus that attract Kid Kaos to shatter the calm.
Eventually these Inflationary Ripples meet some kind of resistance and bounce back as counter-ripples. The initial counter-ripples were relatively easy to predict because of the calm initial conditions. As these counter-ripples crash into the original ripples, some waves get canceled out due to “destructive interference” (see the embedded thread above about Destructive and Constructive Interference), resulting in Deflationary Counter-Ripples that counteract some of the Inflationary Ripples.
These Deflationary Counter-Ripples can be classified into 2 categories: 1. overt attempts by a Hawkish Fed to slow things down, and 2. negative feedback loop dynamics playing out as demand destruction for goods and services ( “the cure for high prices is high prices”). Both kinds of counter-ripples can lead to declines in asset prices of all stripes, ranging from “high duration” assets like Crypto and tech stocks to commodities, real estate, rents, etc. When prices come down, they restore some measure of localized calm again, loosening financial conditions and restoring some measure of demand.
Because ripples move in chaotic fashion, sometimes “constructive interference” can also happen, resulting in overlapping waves that augment instead of canceling one another. These are the so-called “reflexive,” positive feedback loop dynamics.
The strong USD Wrecking Ball resultant from hawkish Fed policy is an example of such an Inflationary Augmented-Ripple because of the primacy of the USD in world trade. The fact that most commodities are priced in USD creates a complicated dynamic that first results in a Deflationary Counter-Ripple/negative feedback loop dynamic in the US even as it simultaneously creates a reflexive/positive feedback dynamic that exacerbates inflation for the the rest of the world.
Eventually, ripples and counter-ripples create their own sets of counter-ripples, some of which augment one another and some of which cancel one another. The result is a choppy, directionless mess of water where it is impossible to see any semblance of reflection — a good metaphor for low signal quality.
The Macroeconomic Pond is now in this state of infinite choppiness, as endless permutations of ripples and counter-ripples interact in a soup of chaos.
Welcome to the Big Chop.
When an overly strong USD Wrecking Ball prompted multiple CB interventions to stave off crises ranging from preventing bond market blowups (UK, EU, Japan) to preventing the importation of commodity inflation (China, Japan), these counter-ripples ironically loosened financial conditions here in the US by weakening the USD, which then rallied asset prices and ironically augmented the original Inflationary Ripples.
An interesting extension of this Mental Model is that these ripples and counter-ripples eventually cancel each other out, i.e. the amplitudes of the counter-ripples become progressively smaller, which neatly captures the lack of volatility in the market right now.
The biggest danger I see right now is over-trading the Big Chop and latching onto every ripple and counter-ripple as if it were the beginning of a momentous new regime: Risk On! Risk Off! Fed Pivot! Market About To Crash! China Re-Opening! Peak USD! Here Comes $200 Oil!
Maybe the waters need to calm down a bit before one can see a reflection again?
Put another way, the “calm pond” of initial conditions at the end of 2021 paved the way for some strong, identifiable trends: Risk-Off in both Equities and Bonds and other Inflation Capacitors. Now that we’re in a choppy pond of ripples and counter-ripples, it has become much more difficult to identify clear trends, and perhaps the better modus operandi as an investor is to at least question/challenge the idea that every ripple is actually the beginning of a large wave.
I have more questions than answers right now:
Are risk markets rallying because the inverted yield curve is forecasting something really bad, thereby leading to an inflection in Fed policy? Or are they rallying just because of this perception leading to a reality of easing financial conditions leading to a soft landing?
Has the USD come off its 2022 highs for similar reasons? Or have CB interventions painted a false picture of easing FCI? Has the USD truly peaked, in which case, FCI eases further and stokes Inflation? Or will persistently high Inflation and weaker economies in RoW lead to a resurgence in the USD, which then feeds back to tighter FCI and lower valuations?
Has the decline in Oil prices from 2022 highs resulted from the strong USD and are effects of demand destruction just being felt? Or have prices come down far enough to stave off demand destruction and are they about to refuel a rise in Inflation?
Obviously, no Mental Model is perfect for capturing reality, but this picture of chaotic, interfering ripples and counter-ripples is how I view the world right now. To me, guesstimating what the latest CPI print will be or what the next FOMC action will be is akin to trying to read meaning into each ripple or counter-ripple in the current chaos. From where I sit, I prefer to clip Treasury Bill coupons until I can see the reflection in the pond again.