“…falling oil prices have a strong secondary effect on Federal Reserve interest-rate policy.” – John Mauldin
According to Wikipedia, “Chaos theory studies the behavior of dynamical systems that are highly sensitive to initial conditions. Small differences in initial conditions yield widely diverging outcomes for such dynamical systems, rendering long-term prediction impossible in general.” Edward Lorenz, the American mathemetician who coined the term “butterfly effect”, summarized chaos theory as describing a scenario in which “the present determines the future, but the approximate present does not approximately determine the future.”
Another way to think of chaos is to imagine throwing a handful of pebbles into a still pool of water. While the ripple effect of a singular pebble might be easy enough to predict, it is much more difficult to predict the path of a single ripple in light of the knock-on effects of all the other ripples happening simultaneously. The more pebbles that are thrown at once, the more chaotic the combined ripple effect becomes.
Chaos theory is extremely applicable to the world of economics, capital markets and public policy. If the economy is a pool of water, every decision made by every individual, corporation and policy maker is a
pebble (some larger than others) creating its own individual ripple effects. Even non-human elements such as the weather can create waves. The historical track record of economic, capital market and public policy forecasters bears out this truth – none of these things are predictable with any reasonable measure of accuracy, and it’s extremely dangerous to focus on the perceived impact of any one singular input in drawing conclusions about expected outcomes.
The presence of record low interest rates around the world represents one of the more significant stones that have been thrown into the economic pool in recent years. The immediate impact of low rates is evident on some levels but ultimately impossible to fully predict. The second and third-derivative impacts become so complex that they are impossible to even be aware of in some cases, let alone forecast with any accuracy. In this week’s Insight we’re going to look at just one chain reaction that unveils how interest rates, crude oil prices and the economy are all critically linked to one another. (Hat tip to this week’s edition of John Mauldin’s Thoughts From the Frontline which served as the springboard for this post.)
Ripple #1: Low Rates Lead To Dollar Carry Trade
One of the results of low interest rates in the US has been the emergence of what is known as the “dollar carry trade”. Given our developed banking system and the prominence of the US Dollar in the global marketplace, investors all around the world take advantage of cheap lending rates in the US by borrowing in US Dollars and investing those borrowed funds in high-return opportunities across the globe. If, for example, an investor can borrow funds at 2% in the US and invest those funds abroad to earn 7% they can pocket the 5% spread without committing any of their own capital in the process.
One caveat to this is that depending on where the money is ultimately invested, movements in currency will act as a tailwind or headwind to realized returns. As John Mauldin states, “As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.” In contrast, a stronger dollar acts as a headwind to a dollar carry-trade investor as the currency return offsets the return from the underlying investment (the 7% in our example above).
Ripple #2: Dollar Carry Trade Puts Downward Pressure On US Dollar
A number of things, including low interest rates themselves, have put downward pressure on the US Dollar in recent years. The dollar carry trade has been one of those things. The dollars that are borrowed and converted into other currencies add to the supply of dollars for sale in the forex markets while artificially increasing the demand for other currencies. Although the dollar has actually be relatively stable in recent years, it almost certainly would have been stronger had the dollar carry trade not been taking place.
Ripple #3: Soft Dollar Contributes To Higher Oil Prices
There are an immeasurable number of factors that contribute to price discovery in the oil markets, but one of them is certainly the value of the US Dollar which has historically exhibited negative correlation with energy prices. A weaker dollar makes oil more affordable for everyone outside the US and increases the investment demand for commodities in general. Typically, if the dollar is trending lower vs other world currencies, oil prices can generally be expected to be trending higher vs the dollar.
Ripple #4: Higher Oil Prices Light Texas On Fire
Texas’s economy has been on fire and is one of the primary reasons the national economic data in the US has looked relatively decent. Consider the following data as presented by Samuel Rines on NationalInterest.org:
Given the extent to which the Texan economy is levered to energy prices, and the extent to which the national data is levered to Texas, one has to conclude that sky-high oil prices are near the top of the list of factors that have contributed to our nation’s recovery over the past several years.
Ripple #5: Growth In Texas Spurs Shift In Monetary Policy
As we’ve wrote about in The Long Hike the Federal Reserve has embarked on a massive shift in policy stance over the last year. Their latest quantitative easing program is just about wrapped up, and the focus has moved to when they will implement the first interest rate hike. It has been the improvement in the economy, as led by the energy sector in Texas, that has made Yellen and company comfortable enough to begin signaling a future rate hike, which should come at some point in mid-2015 according to the current consensus.
Ripple #6: Dollar Strengthens, Pressures Carry Trade, Depresses Oil, Hurts Recovery Prospects
Ironically, we now see a pattern which seems to suggest, at least in one sense, that low interest rates are self-reinforcing. The speculation over impending interest rate hikes has caused the dollar to strengthen dramatically vs its global counterparts in recent months (see The Cleanest Dirty Shirt). This works against the dollar carry traders and provides an incentive for those trades to be unwound which would only serve to strengthen the dollar further (investors would have to convert foreign currency back into dollars to unwind their trades). The strengthening dollar puts downward pressure on oil prices (see chart) and indirectly threatens the recovery in the United States which would delay any raising of short term interest rates. As Mauldin pointed out in his newsletter this week, William Dudley, the president of the Fed Bank of New York, has cited the strengthening US Dollar as a risk factor in multiple speeches in recent months. The strengthening dollar was also cited in the latest Fed meeting minutes as such.
This is a prime example of chaos theory at work as we ponder the complexity of the global economy. Low interest rates lead to a dollar carry trade, which puts downward pressure on the dollar, which creates upward pressure on oil prices, which spark an economic surge in Texas, which leads to a shift in monetary policy, which calls low interest rates into question and threatens to reverse the entire chain reaction. And this simple analysis does not even account for the many additional ripple effects created each step of the way.
Due to the role of chaos theory in finance and economics, we believe in keeping an open mind and holding economic and policy forecasts loosely. Additionally, the presence of chaos reinforces the need for a disciplined, quantiative approach (like MarketVANE) rather than one that is based on real-time human interpretation and gut level convictions. We certainly want to understand the macro environment to the best of our ability, but our primary value-add will continue to be our long-term focus on planning, process and discipline in our investment approach.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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