Commodity pricing

May 19, 2018

A new paper combines two key aspects of commodity pricing: [1] a rational pricing model based on the present value of future convenience yields of physical commodity holdings, and [2] the activity of financial investors in form of rational short-term trading and contrarian trading. Since convenience yields are related to the scarcity of a commodity and the value of inventories for production and consumption they provide the fundamental anchor of prices. The trading aspect reflects the growing “financialization” of commodity markets. The influence of both fundamentals and trading is backed by empirical evidence. One implication is that adjusted spreads between spot and futures prices, which partly indicate unsustainably high or low convenience yields, are valid trading signals.

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Using yield curve information for FX trading

May 12, 2018

FX carry trading strategies only use short-term interest rates (and forward basis) as signal. Yet both theoretical and empirical research suggests that the whole relative yield curve contains important information on monetary policy and risk premia. In particular, the curvature of a yield curve indicates – to some extent – the speed of adjustment of the short rate towards a longer-term yield. Since relative curvature between two countries is therefore a measure of the relative trajectory of monetary policy it is a valid directional signal for FX trading. Indeed, recent empirical research suggests that this signal is statistically significant. A curvature-based trading rule produces higher Sharpe ratios and less negative skewness than conventional FX carry strategies.

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Update on the great public debt issue

May 5, 2018

The latest IMF fiscal monitor is a stark reminder of the public finance risks in the world. Public debt ratios have remained stuck near record highs of 105% of GDP for the developed world and a 3-decade high of 50% for EM countries. If one includes contingent liabilities public debt would average over 200% of GDP in advanced economies and 112% in emerging economies. Deficits remain sizeable in the developed and emerging world, notwithstanding the mature stage of the business cycle. Overall the financial position of governments today is a lot more precarious than during past recoveries, leaving them ill prepared for future adverse shocks. The U.S. is even easing fiscal policy, expanding its deficit and an already high debt ratio. Also, China’s public debt stock is expected to rise rapidly in future years.

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Fixed income carry as trading signal

April 28, 2018

Empirical evidence for 27 markets suggests that carry on interest rate swaps has been positively correlated with subsequent returns for the past two decades. Indeed, a naïve strategy following carry as signal has produced respectable risk-adjusted returns. However, this positive past performance masks the fundamental flaw of the carry signal: it disregards the expected future drift in interest rates and favours receiver position in markets with very low real rates. In the 2000s and 2010s this oversight mattered little because inflation and yields drifted broadly lower. If the inflation cycle turns or just stabilizes, however, short-term rates normalization should become very consequential. Indeed, enhancing the IRS carry signal by a plausible medium term drift in short rates has already in the past produced more stable returns and more convincing actual “alpha”.

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The correlation risk premium

April 21, 2018

The correlation risk premium is a premium for uncertainty of future correlation of securities among each other or with a benchmark. A rise in correlation reduces diversification benefits. The common adage that in a crash ‘all correlations go to one’ reflects that there is typically not much diversification in large market downturns and systemic crises, except through outright shorts. Correlation risk premia can be estimated based on option prices and their implied correlation across stocks. There is evidence that these estimates are useful predictors for long-term individual stock performance, over and above the predictive power of variance risk premia.

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Understanding collateral runs

April 14, 2018

In normal financial runs lenders want their money back. In collateral runs borrowers want their collateral back. In today’s highly collateralized financial system the institutions at risk are broker-dealers that lend and borrow cash in secured transactions and that use part of that liquidity to fund their own asset holdings. In collateral runs cash borrowers, such as hedge funds, have an incentive to rush to repay secured loans as soon as the liquidity of a broker-dealer is being questioned. That is because haircuts keep collateral value above loan notional. The demise of Bear Sterns in 2008 illustrates that the peril of collateral runs is real. Still, this source of liquidity risk has not been well explored.

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How to prepare for the next systemic crisis

April 7, 2018

Systemic crises are rare. But they are make-or-break events for long-term performance and social relevance of investment managers. In systemic crises conventional investment strategies lose big. The rules of efficient positioning are turned upside down. Trends follow distressed flows away from best value and institutions abandon return optimization for the sake of preserving capital and liquidity. It is hard to predict systemic events, but through consistent research it is possible to improve judgment on systemic vulnerabilities. When crisis-like dynamics get underway this is crucial for liquidating early, following the right trends and avoiding trades in extreme illiquidity. Crisis opportunities favor the prepared, who has set up emergency protocols, a realistic calibration of tail risk and an active exchange of market risk information with other managers and institutions.

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The passive investment boom and its consequences

March 31, 2018

Passive investment vehicles have been expanding rapidly over the past 10 years, with assets reaching about USD8 trillion or 20% of aggregate investment funds last year. ETFs alone now account for 14% of fund assets. Beyond, the share of informal passive investing, such as ‘closet indexing’, is probably even larger. The plausible consequences of the passive investment boom include [i] less information efficiency of markets, [ii] greater incentive for low-quality issuance and corporate leverage, [iii] greater price correlation across securities, and [iv] stronger transmission of financial shocks into emerging economies.

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Modern financial system leverage

March 24, 2018

Leverage in modern financial systems arises from bank balance sheets and off-balance sheet transactions that involve banks and other financial institution. Non-bank funding of banks and credit is large, rising, and not fully captured in official statistics. Collateralized transactions and wealth management products are important underappreciated parts of system leverage. The classic narrow focus on bank credit-to-GDP ratios does not only underestimate leverage in size, but also overestimates the stability of sources of funding.

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Interest rate swap returns: empirical lessons

March 17, 2018

Interest rate swaps trade duration risk across developed and emerging markets. Since 2000 fixed rate receivers have posted positive returns in 26 of 27 markets. Returns have been positively correlated across virtually all countries, even though low yield swaps correlated negatively with global equities and high-yield swaps positively. IRS returns have posted fat tails in all markets, i.e. a greater proclivity to outliers than would be expected from a normal distribution. Active volatility management failed to contain extreme returns. Relative IRS positions across countries can be calibrated based on estimated relative standard deviations and allow setting up more country-specific trades. However, such relative IRS positions have even fatter tails and carry more directional risk. Regression-based hedging goes a long way in reducing directionality, even if risk correlations are circumstantial rather than structural.

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asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation carry China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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