"tangled like a ball of string"
At the core of the financial system lies the heartwood. Everything else just surrounds and supports it.
There is a phenomenon, a reality, a perception, a fundamental, a receiving entity. And there is a conception, an insight, a memory, a hope, a delusion, a participating entity. Simultaneously, there is nurturing and milking, harvesting and sowing, financing and reaping dividends. There is existence, delight, profitable carry, a bubble, and the creation of liquidity, as well as the suppression of volatility. Then there is impermanence, a change, a shift, an escape, a pop, and with it the mass of suffering. This is the network of the financial system, where countless cycles of growth and decline occur in the towering skyscrapers of Manhattan, conferences held in California, board meetings of oil companies, councils of Arab princes, financial exchanges in Chicago, as well as on Twitter threads and Reddit forums.
Example 1. A rich Country A is increasing liquidity, while growth and inflation opportunities meager in its own country. International investors are eagerly looking for opportunities. They find an untapped market in Country B, which offers a high differential short-term interest rate. Investors take the liquidity from Country A and moves it to Country B, inflation in Country B decreases, making the country more competitive in the global market. As a result, the country experiences a surge in growth, leaving ecstatic investors congratulating themselves on their investment in Country B.
This phenomena attracts opportunistic corporations, international investors, and policy makers, leading to a period of low volatility and high liquidity. However, any unforeseen event in the rich Country A, such as a decrease in growth, an increase in inflation, or a negative announcement from the central bank chief, triggers a withdrawal of liquidity from Country B back to Country A. Consequently, Country B faces a lower currency value, higher inflation, lower growth, and a reduction in liquidity, resulting in a detrimental liquidity crisis.
This crisis affects Country B’s households, non-financial firms, financial corporations, and central banks, all of whom witness a depletion of reserves. Panic ensues as everyone tries to escape the situation, leading to widespread suffering until external liquidity returns.
Example 2. A long-awaited recovery regime has finally arrived. The period of helpless waiting has ended, and the circumstances are favorable for certain corporations and investors. Any existing growth is now accelerated, and investors are experiencing positive returns in their portfolios. Buying power has increased, leading to a resumption of funding for growth companies. As a result, more growth is being funded, inflation is decreased due to creative destruction, and liquidity is improving. It's a state of blissful Lalaland.
However, this optimistic state is randomly disrupted when a bomb explodes near a war zone rich in commodities. The prices of commodities start to rise, causing an increase in inflation and a reduction in liquidity. The cost of growth also increases, leading to a decrease in funded growth. This creates a vicious loop that results in a reduction in sales and cash flow from investors. The impact is multiplied, leading to a significant explosion of suffering and losses.
A Systematic Framework
There are three types of stages -
The conception stage is characterized by high volatility and high potential rewards.
The existential trend-following stage is characterized by medium volatility and mediocre returns. The stronger the conception, the stronger and more profitable this stage will be.
The bursting of delusion stage is characterized by high volatility and low returns. The stronger the existential stage, the greater the suffering.
There are three factors for a strong conception:
A perceived fundamental opportunity (such as a significant yield differential).
Historical consciousness of delight and profit.
Gathering of masses and manufacturing of social consciousness.
Enforcement of Existential Stage Depends on -
The strength of the social construction of reality.
A circular feedback loop causes the yield differential to remain wider due to self-reinforcement, either from rising growth or falling inflation.
This leads to a decrease in volatility, an increase in liquidity, and an increase in profits, creating a delightful stage of pride and envy.
Volatility traders, liquidity providers, and free riders gather around the social construct, further strengthening it.
Eventually, total dominance is achieved over all naysayers.
The bursting of the Delusion Phenomena depends on:
Excessive greed leading to reckless behaviors in the existential phase.
An external financial event causing a rapid convergence of yield differentials.
Yield differentials converging due to intrinsic events such as a decrease in the growth of a corporation or country.
A regime shift.
An event causing faltering liquidity or rising volatility, such as commodities inflation, a war, or a natural disaster.
How to Create a Stellar Diversified Portfolio
Some yield differentials are seasonal, such as economic regimes. To take advantage of this, make 4-5 bets diversified by geography, based on the next seasonal regime.
Some yield differentials are young and structural, such as technological, economic, and social revolutions. Find 4-5 uncorrelated bets in these areas.
Some yield differentials are in an excessive stage, which makes them prone to greed and recklessness. Place bets against 2-3 of these differentials.