The Financial “Butterfly Effect.”

The “Butterfly Effect” is a theory that postulates that a small change in the initial condition of a system causes a chain effect that can change the outcome of an event. The example often used is that a butterfly flapping its wings in South America can affect the trajectory of a hurricane headed for Texas. In other words a small event can change the outcome and lead to large scale alterations of events.

With world economies interdependent in a delicate financial web, any small change can cause ripples that spread across the entire system. Over this past month of January 2014, we’ve seen several butterfly events. The first one started in China. The Bloomberg headline read: “Chinese Default Swaps at 14 month high. Second biggest economy faces default test in $1.7 Trillion market for Trust flops.” The expectation was that China’s banks would bail out these trusts. However, the Industrial and Commercial Bank of China Trust denied it would pay 50% of share debt. The assets of China’s 67 trusts climbed 60% to $1.67 Trillion in the latest 12 months ending in September.2013 (Bloomberg 1-26-2014). The flapping of China’s butterfly wings started a contagion of jitters that hit the Asian markets and spread to Europe and then the US. That was followed by a report that China’s factory output contracted for the first time in six months.

At the same time the US Federal Reserve flapped its butterfly wings by reducing the amount to quantitative stimulus by a second round of $10 Billion monthly cuts, bringing them down to $65 Billion per month. As a consequence the US dollar had a strong rally, with a corresponding drop in other world currencies that are tied to the US Dollar. The Euro fell from $1.38 to $1,3486. This affected the currencies of Turkey, India and Argentina. It had the effect of pushing up interest rates. Turkey raised its repo rate from 3.5% to 10%. India, suffering from inflation, raised its interest rates to 7% from 5%.. Argentina, that has a prior reputation of default, saw their bond yields rise.

The ripples have crept into the US Stock market. The VIX index is a measure of “fear” among investors. In the past week the VIX rose to its highest level in three months. The S & P was down to 1782 a loss of 3.6% for the year to date. The US benchmark 10 Year Note fell 38 basis points for the month of January. A drop the price means a rise in interest rates. Interest rates move “inverse” to the price.

Meanwhile, we’ve seen a squeeze on middle income Americans. Disposable income fell 2.7% in the past 12 months. For all of 2013, consumer spending was up only 3.1%, the smallest since 2009. These are important numbers because consumer spending accounts for 70% of GDP. In December 2013, that is supposed to be the strongest month for retailers, consumer spending rose a meager .2%.

For investors, these events bear watching. The markets have become real choppy, rising sharply one day, then falling sharply the next. The US economy is still the strongest in the world. With economies in developing countries weakening, we could see a continued influx of foreign capital fleeing their countries of origin into the US Dollar. This could be the catalyst that keeps the US economy stable and growing.

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