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.

(more…)

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.

(more…)

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.

(more…)

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.

(more…)

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.

(more…)

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.

(more…)

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.

(more…)

Cash hoarding and market dynamics

March 11, 2017

Institutional asset managers can aggravate market swings due to the pro-cyclicality of redemptions, internal leverage and cash positions. A new empirical analysis shows that cash hoarding, a rise in funds’ cash positions in times of redemptions, is the norm. Cash hoarding seems to be particularly pronounced in less liquid markets and is a rational response if fire sale haircuts are prone to escalate with growing flows, i.e. if liquidating late is disproportionately costly. Investment opportunities arise initially from timely positioning and subsequently from the detection of flow-driven price distortions.

(more…)

Fake alpha

March 4, 2017

Statistical alpha can be divided into fake alpha, which is a premium for non-directional systematic risk, and true alpha, which reflects the quality of the investment process. Fake alpha arises from exposure to conventional factors that are not correlated with the market portfolio. Failing to distinguish fake and true alpha can be costly for investors and strategy developers. Fake alpha is easy and cheap to produce and after periods of high risk premia on conventional factors it can post impressive performance statistics (or backtests). Subsequently, investors overload on managers or strategies that use these factors and related performance inevitably deteriorates. This goes some way in explaining the negative historic alpha on actively managed funds.

(more…)

Equity alpha through volatility targeting

February 25, 2017

Volatility targeting has historically enhanced the statistical alpha of standard equity strategies. That is because volatility is more predictable in the short-term than returns. Thus, Sharpe ratios tend to decline, when volatility rises. Expected returns increase after turmoil but only overtime, when volatility might already be subsiding. On its own volatility is not a pure measure of risk premia and does not indicate if actual risk is overstated or underappreciated. A flipside of mechanical volatility targeting is that it contributes to herding and escalatory price dynamics.

(more…)

Topics - Browse by tag

Research
Quantamental Academy
About Us
Macro-quantamental investment handbook