Understanding negative inflation risk premia

May 13, 2017

Inflation risk premia in the U.S. and the euro area have disappeared or even turned negative since the great financial crisis, according to various studies. There is also evidence that this is not because inflation uncertainty has declined but because the balance of risk has shifted from high inflation problems to deflationary recessions. Put simply, markets pay a premium for bonds and interest rate swap receivers as hedge against deflation risk rather than demanding a discount for exposure to high inflation risk. This can hold for as long as the expected correlation between economic-financial performance and inflation remains broadly positive.

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Volatility risk premia in the commodity space

May 6, 2017

Volatility risk premia – differences between options-implied and actual volatility – are valid predictors for risky asset returns. High premia typically indicate high surcharges for the risk of changes in volatility, which are paid by investors with strong preference for more stable returns. For commodities volatility risk premia should have become a greater factor as consequence of their “financialization”. New evidence suggests that indeed volatility risk premia on commodity currencies have predictive power for subsequent commodity returns, while crude and gold premia have predictive power for other asset classes in accordance with the nature of these commodities. Since estimation of these premia takes some skill and judgment this points to opportunities for macro trading with econometric support.

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Building international financial conditions indices

April 29, 2017

IMF staff has developed global financial conditions indices for 43 global economies. Conceptually, these indices extract the communal component of range of indicators for local financing conditions, independent of economic conditions. The idea looks like a good basic principle for building FCIs for macro trading strategies. The research on these indices suggests that [1] financial conditions are a warning sign for recessions, and [2] global financial shocks have a powerful impact on local conditions, particularly in the short run and in emerging economies.

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The global effects of a U.S. term premium shock

April 22, 2017

Empirical research suggests that shocks to U.S. treasury term premia have had a persistent subsequent impact on term premia in other developed and emerging fixed income markets. Global financial integration and inflation seem to increase the sensitivity of non-U.S. markets. A 200bps rise in the U.S. premium from current compressed levels could boost the term premia in other countries between 50 and 175 basis points. Hence, a U.S. shift towards reflationary policies or greater net supply of long-term treasuries could greatly increase borrowing costs around the world, exposing weaknesses in overleveraged economies and sectors.

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Watching U.S. financial conditions

April 15, 2017

The U.S. financial system wields dominant influence over the national and global economies. Moreover, securities and derivatives markets play a greater role relative to banks and compared to other developed countries. Medium-term shifts in financial conditions, rather than short-term changes, should be consequential for economic growth and monetary policy. Therefore, a timely and consistent measurement of U.S. financial conditions is crucial for macro trading strategies. A broad econometric measure of U.S. financial conditions based on risk, liquidity and leverage is produced and regularly updated by the Chicago Fed.

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Nowcasting GDP growth

April 8, 2017

Financial markets have long struggled with tracking GDP growth trends in a timely and consistent fashion. However, over the past decade statistical methods for “nowcasting” various economies have improved considerably, benefiting macro trading strategies. Dynamic factor models have become the method of choice for this purpose: they extract the communal underlying factor behind timely economic reports and translate the information of many data series into a single underlying trend. The estimation process may look daunting, but its basics are intuitive and calculation is executable in statistical programming language R.

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Trend following and the headwinds of rising yields

April 2, 2017

The decline in bond yields over the past decades has supported profitability and diversification value of trend followers. Returns have been boosted by a persistent secular downward drift in interest rates and persistent positive carry. Diversification value owed to negative correlation of long duration positions with equity and credit returns, reflecting the dominance of deflationary over inflationary shocks. However, in a rising yield environment carry would work against the trend follower, while diversification value is dubious. A simple simulation that reverses the yield dynamics over the past 15 years suggests that a generic trend following strategy could perform poorly in a rising yield environment.

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FX returns and external balances

March 29, 2017

A new paper supports the view that currency excess returns can to some extent be viewed as compensation for risk to net capital flows in imperfect markets. An increase in current account uncertainty can be approximated by economists’ forecast dispersion. Historically, a rise in current account uncertainty has reduced returns on carry currencies and investment currencies, i.e. those of countries with net capital inflows. There is also evidence that markets have been sluggish in adapting to higher uncertainty.

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FX carry trade crashes

March 25, 2017

A global historical analysis of FX carry trades shows positive long-term performance but a negative skew of returns. Large drawdowns have been associated with global financial stress. This supports the view that FX carry returns are to some extent a premium for undiversifiable risk. FX carry trade crashes have been diverse in duration and size, exceeding 2 years and 30% in extreme episodes. Historically, high carry and positive valuation metrics have shortened the duration of sell-offs in FX carry portfolios. Financial stress in the developed world has prolonged the duration of drawdowns of developed market FX carry trades.

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Measuring non-conventional monetary policy surprises

March 18, 2017

A new paper proposes a measure for monetary policy surprises that arise from asset purchases and forward guidance. The idea is to estimate the change in the first principal component of government bond yields at different maturities to the extent that it is independent of changes in the policy reference rate and on days of significant policy statements. Such identified non-conventional policy shocks have had a persistent impact on yield curves and exchange rates since 2000. Their monitoring is important for so-called “long-long” risk parity trades.

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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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