{"id":80761,"date":"2021-03-22T12:10:00","date_gmt":"2021-03-22T16:10:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=80761"},"modified":"2023-02-10T13:33:15","modified_gmt":"2023-02-10T18:33:15","slug":"the-butterfly-effect-in-us-equities","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/macro\/the-butterfly-effect-in-us-equities\/","title":{"rendered":"The Butterfly Effect in US Equities"},"content":{"rendered":"\n<p class=\"wp-block-paragraph\">I imagine that many readers are familiar with the term \u201c<a href=\"https:\/\/en.wikipedia.org\/wiki\/Butterfly_effect\">butterfly effect<\/a>\u201d.&nbsp; In common parlance, its oversimplified definition is that a large weather system can be influenced by a small perturbation, such as a butterfly flapping its wings thousands of miles away.&nbsp; In actuality, it describes an aspect of <a href=\"https:\/\/en.wikipedia.org\/wiki\/Chaos_theory\">chaos theory<\/a> when \u201ca small change in one state of a&nbsp;<a href=\"https:\/\/en.wikipedia.org\/wiki\/Deterministic_system\">deterministic<\/a>&nbsp;<a href=\"https:\/\/en.wikipedia.org\/wiki\/Nonlinear_system\">nonlinear system<\/a>&nbsp;can result in large differences in a later state.\u201d&nbsp; We can write dissertations about whether markets are deterministic and nonlinear, and to what degree chaos theory is applicable to markets<sup>[i]<\/sup>, but this morning\u2019s market activity appears to be a wonderful illustration of the butterfly effect in US equity markets.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">On Friday evening I got an alert on my phone saying that the Turkish president removed the country\u2019s central bank governor.&nbsp; My trading week was over by the time the news arrived, with a quarterly triple (<a href=\"\/campus\/traders-insight\/securities\/futures\/quadruple-witching-got-a-downgrade\/\">not quadruple<\/a>) witching expiration behind us.&nbsp; I have to admit, my first thought was not \u201cI need to buy NQ futures on Sunday night\u201d, but that&nbsp; would have become a solid trade by the time that US markets opened on Monday.&nbsp;&nbsp; It appears that the news out of Turkey is another example of the butterfly effect in global financial markets.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">I am by no means an expert in Turkish politics, but it is hardly a sign of economic stability when a president fires his third central bank governor in less than two years.&nbsp; Markets are not happy when central bank independence is threatened, let alone usurped by political leaders, especially when that becomes somewhat routine.&nbsp; No one should have been surprised that the Turkish lira plunged by more than 15% against the US dollar (it has since improved to -10% today) or that major Turkish equity indices fell by about 10% this morning.&nbsp; While it is not uncommon for local stock indices to rise when a nation\u2019s currency is devalued, that occurs when investors believe that the weaker currency will spur exports.&nbsp;&nbsp; That was not the interpretation for investors in Turkish assets.&nbsp; Markets gave this move a true vote of no confidence.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">It is therefore not surprising that US Treasury bills and notes rallied this morning.&nbsp; US Treasuries are considered a haven by much of the world\u2019s investment community, and benefit from a \u201cflight to safety\u201d bid.&nbsp; Turkish investors, along with those in other emerging markets, sought protection in Treasuries and other safe assets.&nbsp; Prices of those assets rose, pushing yields lower.&nbsp; The combination of a flight to safety bid and a somewhat oversold bond market led to a 3 basis point reduction in the key 10-year yield.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">That would normally be the start of a \u201crisk-off\u201d day for the markets.&nbsp; But the situation in Turkey was relatively contained.&nbsp; There are few signs of contagion throughout other emerging markets and European banks.&nbsp; Thus, with the rest of the world still in a generally \u201crisk-on\u201d mood, traders were free to interpret the bond markets\u2019 moves in a positive light.&nbsp; Over recent sessions, there has been a definite correlation between 10-year note rates and the NASDAQ 100 Index (NDX).&nbsp; By one measure, they have an R^2 of about 0.80, which is substantial<sup>[ii]<\/sup>.&nbsp; If ordinary investors and the media notice this correlation, we can be certain that algorithms are already taking advantage of this relationship.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">We can argue whether there is causation as well as correlation in the relationship between 10-year notes and NDX (space simply does not permit it here), but it is clear that traders would be reacting favorably to a decline in yields as long as the risk-off mentality is limited to a specific region and set of investors.&nbsp; (Other risk-off assets like gold failed to find a bid and traded lower.) Thus, the risk-off mentality that took root in Turkey led to a rally in NDX and many of its key components<sup>[iii]<\/sup>.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">That, dear readers, is an example of the butterfly effect in global markets and specifically in US equities.&nbsp; A central bank governor in Turkey, someone who has virtually no effect on US technology shares on a daily basis, is fired.&nbsp; That led to a flight to safety bid in US Treasuries as investors fled the Turkish lira, which in turn led to bid for the NDX index and its components.&nbsp; A small change in one part of the system led to a large influence elsewhere.<\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n\n\n\n<p class=\"wp-block-paragraph\">[i] My takes: markets are not deterministic, since randomness is certainly involved in the development of future stages in the system; they are almost definitely nonlinear, since changes in output are quite frequently not directly proportional to inputs; and that there are many applications of chaos theory to investing.&nbsp; Markets are clearly chaotic, but I would argue that markets are non-deterministic and not truly subject to the tenets of chaos theory.&nbsp; Yet there is a fractal nature to markets \u2013 think of how intraday charts can resemble long term charts \u2013 and strange attractors appear to exist.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">[ii] Here is a graph from Bloomberg that shows the high recent correlation between percentage moves in the front month Treasury Note (TYM1) and NASDAQ (NQM1) futures:<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" width=\"1100\" height=\"515\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-1100x515.png\" alt=\"Treasury Note (TYM1) and NASDAQ (NQM1) futures\" class=\"wp-image-80763 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-1100x515.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-700x328.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-300x140.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-768x360.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1-1536x719.png 1536w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2021\/03\/TYM1-vs-NQM1.png 1903w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/515;\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">[iii] Another key factor positively affecting NDX was the $3,000 price target placed upon Tesla (TSLA) by Cathie Wood of Ark Management.&nbsp; One could certainly question the objectivity of an asset manager placing an outlandish price target on her largest holding, but <a href=\"\/campus\/traders-insight\/securities\/macro\/ark-of-schadenfreude\/\">I\u2019ll avoid that fray<\/a> for now.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>This morning\u2019s market activity appears to be a wonderful illustration of the butterfly effect in US equity markets.<\/p>\n","protected":false},"author":4,"featured_media":80766,"comment_status":"closed","ping_status":"open","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[21,5,15,16,17,14700,18,6,8,9,22,26,3],"tags":[9407,2884,2464],"contributors-categories":[13576],"class_list":["post-80761","post","type-post","status-publish","format-standard","has-post-thumbnail","category-commodities","category-europe-middle-east-africa","category-fixed-income","category-forex","category-futures","category-ibkr-market-insights","category-macro","category-north-america","category-region","category-securities","category-stocks","category-text-articles","category-traders-insight","tag-butterfly-effect","tag-equity-market","tag-us-dollar","contributors-categories-interactive-brokers"],"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- 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