Three Examples Of How Chaos Theory Affects Financial Markets

Chaos Theory – the idea that a butterfly in Thailand could cause a US hurricane – can actually create positive outcomes as well as mayhem. Consider that European banks, German long-term bunds and the offshore yuan are essentially the butterflies making for pleasant investment conditions just now. All have turned sharply in the last 2 months after previous discounting disaster. And all have more room to run.

Chaos Theory gets a bum wrap, and I think the reason is bad branding. The most common explanation of the phenomenon is the classic “a butterfly flapping its wings in Thailand can cause a hurricane in the Gulf of Mexico”. Initial conditions, in other words, can have outsized effects in complex systems like weather patterns. Fair enough, but one usually associates Chaos Theory with bad outcomes like cyclones and stock market crashes.

What about when initial conditions push their way through to create unexpectedly good outcomes? That’s Chaos Theory as well, but no one talks about the mayhem created by a lovely day… Bad branding, that, or at least misleading packaging…

Turning to the current sunny spell in global risk markets, three examples of why Chaos Theory can work to investors’ benefit as well as harm.

Exhibit #1: European Bank Stocks:

In early August, the EURO STOXX Banks Index looked like it was about to implode. At 77, it had not been lower since the 1990s. We wrote about it, highlighting that several market bears thought the group was destined to go into chaotic (there’s that word again) free-fall.

But then the group found its footing as Eurozone long-term interest rates bottomed (more on that in a minute).
From August 15th to now, the index is up 20%. Disaster averted, at least for now.

The group’s move has lit a fire under global bank stocks. US large cap Financials are up 12% since mid August. Small caps are +8% and Japanese banks are +14%.

Here is a 5-year chart of the index to give you some historical perspective:

Bottom line: European banks are the Lake Victoria of the current rally in global financials and therefore also the source waters for the ongoing lift in value stocks.

Exhibit #2: German 30-year sovereign bonds:

Since the German government runs a balanced budget, long-term bunds are in perennial short supply relative to US Treasuries.
Along with that, the long duration of German 30-years makes this asset singularly twitchy to market sentiment about Eurozone economic growth.

At the end of August, when US-China trade talks were at their nadir, the market for 30-year bunds was signaling the real risk of a deep European recession. Yields got as low as -0.27%.

Now, the yield on 30-year bunds is positive again to the tune of 0.16%. Ok, not great but also not (quite) staring into the abyss. Treasuries have followed along, assuaging concerns created by a previously inverted yield curve.

Here is a 5-year yield chart for this paper:

Bottom line: the lift in long-term German yields since late August was the spark that reignited the global market’s animal spirits in September and October. Europe may be teetering on the edge of recession, but lessening US-China trade tensions may save it from falling into too deep a hole.

Exhibit #3: The offshore yuan/dollar exchange rate:
When the offshore yuan blew through the old “line in the sand” level of 7/$ in early August, you knew markets were worried US-China trade talks were sputtering.
These reached their peak in early September, at 7.19/$.
Since then, the yuan has crawled its way back to (almost) 7.0, closing today at 7.03.

Here is a 1-year chart for the offshore yuan:

Bottom line: even if US-China trade talks seem unpredictable, yuan traders are expressing confidence that they remain on the right track. That feeds into global capital markets’ bullish tone just now.

In summary, these are the 3 butterflies of the current global equity rally, each flapping their wings on distant shores but in aggregate creating something productive rather than “chaos”. A look at the chart for each shows they all have room to run. As such, they are the 3 indicators we’ll be watching most closely. For now, however, this is one example of Chaos Theory that is working in investors’ favor.

- Source, Zero Hedge