Macro-quantamental factors
Terms of trade measure an economy’s ratio of export prices to import prices. Changes in these ratios drive divergences in economic performance across currency areas and influence foreign exchange and other asset market returns. Consequently, timely estimates of terms-of-trade dynamics, often derived from commodity prices, have long been valued as leading indicators by investors. Today, point-in-time versions of these measures provide a robust foundation for statistical analysis and backtesting of systematic strategies.
This post illustrates the trading value of real-time terms-of-trade changes through five simple strategies. Individually, such single-signal strategies yield only modest standalone performance ratios. However, their profit-and-loss streams are largely uncorrelated with major market benchmarks and only moderately correlated with each other. This suggests that, when applied systematically and across a broad set of markets, terms-of-trade dynamics can serve as a significant and independent source of true alpha in systematic macro trading.
Central banks regularly adjust the economy’s monetary base through foreign exchange interventions and open market operations. Point-in-time information on such intervention-based liquidity expansion has predictive power for asset returns. That is because such operations often come in longer-term trends, and there are lagged effects, for example, through private sector portfolio rebalancing.
Alas, the discovery of the economic value of intervention-liquidity signals is often obscured by “ugly backtests”: as a single type of information applied to a single asset type, simulations typically show patchy relevance and uneven value profiles. However, across strategy types and asset classes, intervention-driven liquidity growth has consistently contributed value. A simulation combining two directional and two relative-value strategies demonstrates steady and meaningful PnL generation with low correlation to major market benchmarks.
There are plausible relations between past and future short-term trends across and within financial markets. This is because market returns affect expected physical payoffs, risk premia, and the monetary policy outlook. However, the relations between past and future returns are unstable and often depend on the economic environment.
As an example, this post shows that the impact of short-term commodity future trends on subsequent S&P500 future returns depends on the inflationary pressure in the U.S. economy. Empirical analysis suggests that macro-conditional trend signals outperform unconditional short-term trend signals regarding predictive power, accuracy and naïve PnL generations.
Rising inflation is a natural headwind for equity markets in economies with inflation-targeting central banks. As consumer prices accelerate, expected monetary policy rates and discount factors tend to increase more than dividend growth. Over the past three and a half decades, there has been a strong negative correlation between changes in reported inflation and simultaneous global equity futures returns. A similar negative relationship is evident between seasonally adjusted CPI trends and concurrent returns.
Furthermore, inflation dynamics have shown predictive power. Short-term changes and trends in consumer price growth have proven to be valuable early warning signals for serious market downturns and leading indicators of recoveries. Also, inflation-sensitive strategies have performed on par with long-only portfolios during stable periods. Overall, they enhanced risk-adjusted returns by improving the timing of equity risk exposure.
The dividend discount model suggests that stock prices are negatively related to expected real interest rates and positively to earnings growth. The economic position of households or consumers influences both. Consumer strength spurs demand and exerts price pressure, thus pushing up real policy rate expectations. Meanwhile, tight labor markets and high wage growth shift national income from capital to labor.
This post calculates a point-in-time score of consumer strength for 16 countries over almost three decades based on excess private consumption growth, import trends, wage growth, unemployment rates, and employment gains. This consumer strength score and most of its constituents displayed highly significant negative predictive power with regard to equity index returns. Value generation in a simple equity timing model has been material, albeit concentrated on business cycles’ early and late stages.
Real government bond yields are indicators of standard market risk premia and implicit subsidies. They can be estimated by subtracting an estimate of inflation expectations from standard yields. And for credible monetary policy regimes, inflation expectations can be estimated based on concurrent information on recent CPI trends and the future inflation target.
For a data panel of developed markets since 2000, real yields have displayed strong predictive power for subsequent monthly and quarterly government bond returns. Simple real yield-based strategies have added material economic value in 2000-2023 by guiding both intertemporal and cross-country risk allocation.
Bank lending surveys help predict the relative performance of equity and duration positions. Signals of strengthening credit demand and easing lending conditions favor a stronger economy and expanding leverage, benefiting equity positions. Signs of deteriorating credit demand and tightening credit supply bode for a weaker economy and more accommodative monetary policy, benefiting long-duration positions. Empirical evidence for developed markets strongly supports these propositions.
Since 2000, bank survey scores have been a significant predictor of equity versus duration returns. They helped create uncorrelated returns in both asset classes, as well as for a relative asset class book.
Local-currency import growth is a widely underestimated and important indicator of trends in fixed-income markets. Its predictive power reflects its alignment with economic trends that matter for monetary policy: domestic demand, inflation, and effective currency dynamics.
Empirical evidence confirms that import growth has significantly predicted outright duration returns, curve position returns, and cross-currency relative duration returns over the past 22 years. A composite import score would have added considerable economic value to a duration portfolio through timing directional exposure, positioning along the curve, and cross-country allocations.
Excess inflation means consumer price trends over and above the inflation target. In a credible inflation targeting regime, positive excess inflation skews the balance of risks of monetary policy towards tightening. An inflation shortfall tips the risk balance towards easing. Assuming that these shifting balances are not always fully priced by the market, excess inflation in a local currency area should negatively predict local rates market and equity market returns, and positively local-currency FX returns.
Indeed, these hypotheses are strongly supported by empirical evidence for 10 developed markets since 2000. For fixed income and FX excess inflation has not just been a directional but also a relative cross-country trading signal. The deployment of excess inflation as a trading signal across asset classes has added notable economic value.
Employment growth is an important and underestimated macro factor of financial market trends. Since the expansion of jobs relative to the workforce is indicative of changes in slack or tightness in an economy it serves as a predictor of monetary policy and cost pressure. High employment growth is therefore a natural headwind for equity markets. Similarly, the expansion of jobs in one country relative to another is indicative of relative monetary tightening and economic performance. High relative employment growth is therefore a tailwind for the local currency.
These propositions are strongly supported by empirical evidence. Employment growth-based trading signals would have added significant value to directional equity and FX trading strategies since 2000.
Economic growth differentials are plausible predictors of foreign exchange return trends because they are related to differences in monetary policy and return on investment. Suitable metrics for testing growth differentials as trading signals must replicate historic information states. Two types of such metrics based on higher-frequency activity data are [i] technical GDP growth trends, based on standard econometrics, and [ii] intuitive GDP growth trends, mimicking intuitive methods of market economists. Both types have predicted FX forward returns of a set of 28 currencies since 2000.
For simple growth differentials, the statistical probability of positive correlation with subsequent returns has been near 100% with a quite stable relationship across time. Excess growth trends, relative to potential growth proxies, would have been more appropriate predictors for non-directional (hedged) FX forward returns. Correlations with hedged returns have generally been lower but accuracy has been more balanced. Finally, balanced growth differentials that emphasize equally the performance of output and external balances are theoretically a sounder predictor. Indeed, these indicators post even higher and more stable correlations with subsequent directional returns than simple growth differentials.