The Three Body Problem
Comment of the Day

December 29 2017

Commentary by Eoin Treacy

The Three Body Problem

This article by Ben Hunt for Salient Partners may be of interest to subscribers. Here is a section:

It’s not just that we endure large basis risks here in the Hollow Market, unmanageable for many. It’s not just that all of our old signposts and moorings for navigating markets aren’t working very well. It’s not just difficult to identify predictive/derivative patterns in today’s markets. There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns. THIS is basis uncertainty, and it’s as problematic for humans facing markets that don’t make sense as it is for bees facing weather patterns that don’t make sense.

Well, that’s just crazy talk, Ben. What do you mean that it might be impossible to identify predictive/derivative patterns? What do you mean that basis might not exist at all? Of course there’s a pattern to markets and everything else. Of course spring follows winter.

Nope. This is the Three-Body Problem.

Or rather, the Three-Body Problem is a famous example of a system which has no derivative pattern with any predictive power, no applicable algorithm that a human (or a bee) could discover to adapt successfully and turn basis uncertainty into basis risk. In the lingo, there is no “general closed-form solution” to the Three-Body Problem. (It’s also the title of the best science fiction book I’ve read in the past 20 years, by Cixin Liu. Truly a masterpiece. Life and perspective-changing, in fact, both in its depiction of China and its depiction of the game theory of civilization

Eoin Treacy's view

The Three-Body problem and basis uncertainty is a fresh explanation of the concept some commentators refer to as a paradigm shift. In other words, we are so conditioned by the prevailing market conditions that it is almost impossible to imagine what the world would be like without the disinflation which has prevailed since the early 1980s. At a talk in 2015 Jeff Gundlach referred to this problem in terms of summer insects which have no experience of, and therefore cannot imagine, winter. 

One of the most important characteristics of crowds is that they are tolerant of contradiction. In the bond markets the fact Italy has a lower yield that the USA is a contradiction. The existence of negative yields on hundreds of billions of Euro and Swiss Francs is representative of a massive dislocation in the norms of the fixed income markets. High yield issuance in the Eurozone hit another new high this year and the ECB is just about to start tapering its balance sheet.

The mere existence of contradictions is not enough to signal a peak. However, contradictions do tell us where the next source of trouble is likely to be. With the Federal Reserve raising rates, the ECB tapering and China on neutral, Japan is the only major economy running loose monetary and fiscal policy. Against that background the expansion of global central bank balance sheets will have a more difficult time expanding. 

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