A new BIS paper provides important lessons for EMFX carry trades, using Latin America as a case study. First, FX carry opportunities depend on market structure and regulation. Second, observed carry typically contains a classic interest rate differential and an arbitrage premium that reflects the state of on-shore and off-shore markets. Third, liquidity shortages and FX proxy hedging constitute major setback risks.
Over the past 25 years the relation between implied equity volatility (VIX) and market returns has been non-linear. When VIX was low there was no meaningful relation. However, when volatility increased above average higher equity and lower bond returns followed. This is evidence for “flight to quality“, where investors pay a rising premium for safe and liquid assets as volatility increases. Fear of redemptions, liquidity constraints, and deteriorating market intermediation are plausible causes of this effect.
The variance risk premium is paid by risk-averse investors to hedge against variations in future realized volatility. Empirical evidence and intuition suggest that equity markets indeed pay over the odds for downside risk in mark-to-market variations but accept a discount for upside risk. The highest premium is paid for downside skewness risk. These forms of variance risk premia have been significant predictors of U.S. equity returns.
A new BIS paper summarizes motives and impact of FX interventions. Most importantly it looks at the conditions under which such interventions are effective (and hence likely). The strongest case for interventions arises when [i] the central bank has a clear view about an exchange rate misalignment, and [ii] the intervention would not go against the interest rate differential.
An empirical study shows that U.S. mutual funds take two major allocation decisions: bonds versus equity and U.S. versus non-U.S. assets. Federal Reserve policy easing encourages shifts into foreign assets. High uncertainty drives allocations out of risky assets into U.S. treasuries. And the relative performance of foreign versus U.S. assets leads a chase of the higher return. Within fixed income institutions tend to reallocate gradually towards higher prior yields.
A Bank of England paper integrates commodity futures with bond yield curves. It finds that bond factors exert significant influence on commodities. It also finds that risk premia paid in crude oil futures have shifted over the decades from negative to positive, as crude’s hedge value faded with the memory of the oil crises. Gold futures have long paid a positive risk premium for lack of empirical hedge value.
A new IJCB article shows that historically [i] inflation expectations had a strong impact on long-term yields and [ii] economic data surprises had a strong impact on inflation expectations. However, the influence of compensation for inflation and inflation risk on U.S. bond yields has faded in the era of non-conventional monetary policy.
Herding arises from deliberate decisions of informed traders to follow others. It can create inefficiency, dislocations and, hence, profit opportunities. A paper by German academics suggests that herding is the more intense the better informed the market is and the greater the information risk. The paper also finds that both sell-herding and buy-herding increased during the last financial crisis.
A paper by Greenwald, Lettau, and Ludvigson argues that short-term (quarterly) equity price fluctuation arise mainly from changes in risk aversion, while long-term trends (over decades) are heavily influenced by reallocation from labor to capital income. The latter appears to explain all the stock market gains in the U.S. since 1980.
Assessing the risk of equity market “crashes”, academic work has focused on price-earnings ratios and bond-stock earnings yield differentials. A recent paper by Lleo and Ziemba provides theoretical reasoning and empirical support for these warning signs.
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.
