Butterflies and basis points: how small signals can move big markets

4 minute read

When small things make big waves

I have always found the ‘butterfly effect’ to be quite an interesting concept. This idea, taken from chaos theory, basically says that small input changes into a (non-linear) process can result in massive changes in the output of that process. Most people will have come across the concept through a rhetorical question that generally gets expressed as something like: ‘could a butterfly flapping its wings in Texas cause a typhoon in Tokyo?’. There are also lots of sci-fi stories which are based on this idea, often with time-travelling protagonists causing huge changes in the future through small changes in the past (my children have recently enjoyed ‘Back to the Future’ which is a great example of this).

A Japan specific story with global consequences

The recent moves in the Japanese government bond market have made me think a little about how financial markets are often connected in quite obscure ways. Japan was of course the first major economy to experience extended periods of low (near zero) interest rates following the unwind of the growth boom of the 1980s and 1990s. More recently, the Bank of Japan has started the process of increasing base rates from near zero and bond markets have been selling off (i.e. bond yields higher) following the election of new Prime Minister Sanae Takaichi as leader of the ruling Liberal Democrat Party in October. As PM, she has called for greater fiscal spending which has been a concern for bond investors (as it has across the globe). At the same time, she is leveraging her strong standing in political opinion polls to call a snap election in early February, to consolidate her ability to push through those plans.

How Japan’s moves spill into global markets

While this is clearly a distinct Japan story, it is interesting to consider how correlated broader yield and market moves have been over this period. In addition to large Japanese Yen (JPY) denominated bond holdings, Japanese banks and insurers are big owners of international investment grade corporate and government bonds, and international equity – positions built over time as a reflection of low prospective returns in the Japanese markets and higher offshore returns. The recent moves, including when long maturity Japanese government bonds moved >20bps in one day, are likely to have those institutional investors reassessing not just how to reposition their Japanese Government Bond (JGB) portfolios, but likely those international holdings too – with potentially meaningful consequences as those flows hit the market.

Why cause and effect rarely line up cleanly

These complicated dynamics of the potential impact of Japanese policy into US investment grade credit demonstrate how financial markets are some of the noisiest non-linear systems out there. This is important because when putting a trade on the thesis may be predicated on X, Y or Z happening – but attributing the performance ex-post may well be tricky, and indeed it might be that you made money on the position because A, B or C happened.

Building bias to improve your odds

What are we to do about these challenges? Well, it is not as bleak as it all sounds, and we focus on two things to help mitigate some of the noise. Firstly, it’s important to try and build some bias. Simply calling events correctly is tricky, but we have a better chance of getting positive returns if we’re also in markets that for example: are cheaper, or are trending positively, or generate some income while you’re waiting.

Secondly, it’s critical to make sure you’re diversified. We spend a lot of time trying to think of how trades can go wrong – randomness of outcomes is a fact that we have to deal with, so we supplement quantitative work with good old beard scratching and cogitating to make sure we can minimise the risk that our tactical positions fail at once. Getting your legs taken out by a butterfly might be understandable for one trade, but clients (reasonably) have less understanding when this occurs across an entire portfolio.

Sacha Chorley

Portfolio Manager

Sacha is a portfolio manager of the Quilter Investors Cirilium and Creation Portfolios. Prior to joining Quilter Investors in 2011, Sacha worked at Broadstone with their team of economists before moving into asset allocation and fund manager research.

Sacha is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. Sacha has a degree in Maths from the University of Bath.

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