What traders can learn from market price volatility

July 1, 2017

Equity and bond market volatility can be decomposed into persistent and transitory components by means of statistical methods. The distinction is relevant for macro trading because plausibility and empirical research suggest that the persistent component is associated with macroeconomic fundamentals. This means that persistent volatility is an important signal itself and that its sustainability depends on macroeconomic trends and events. Meanwhile, the transitory component, if correctly identified, is more closely associated with market sentiment and can indicate mean-reverting price dynamics.

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Simple international macroeconomics for trading

June 10, 2017

Simple New Keynesian macroeconomic models work well for analyzing the impact of various types of shocks on small open economies and emerging markets. The models are a bit more complex than those for large economies, because one must consider the exchange rate, terms-of-trade and financial pressure. Yet understanding some basic connections between market factors and the overall economy already supports intuition for macro trading strategies. Moreover, the analysis of the effect of various shocks is possible in simple diagrams.

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Simple macroeconomics for trading

June 7, 2017

Most modern dynamic economic models are too complex and ambiguous to support macro trading. A practical alternative is a simplified static model of the “New Keynesian” tradition that combines basic insights from dynamic equilibrium theory with an intuitive and memorable representation. Macro traders can analyse real life events in this framework my shifting curves in a simple diagram. In this way they can analyse the effect of fiscal policy shocks, monetary policy shocks, inflation expectation shocks, economic supply shocks and so forth. Part 1 of this post focuses on a model for a large closed economy (or the world as a whole).

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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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Lessons from long-term global equity performance

February 11, 2017

A truly global and long-term (116 years) data set for both successful and failed financial markets shows that equity has delivered positive long-term performance in each and every country that did not expropriate capital owners, even those that were ravaged by wars. Also, equity significantly outperformed government bonds in every country, with a world average annual return of 5% versus 1.8%. The long-term Sharpe ratio on world equity has been 0.24 versus 0.09 for bonds. Valuation-based strategies for market timing have historically struggled to improve equity portfolio performance. Active management strategies that rely on both valuation and momentum would have been more useful.

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Statistical remedies against macro information overload

February 4, 2017

“Dimension reduction” condenses the information content of a multitude of data series into small manageable set of factors or functions. This reduction is important for forecasting with macro variables because many data series have only limited and highly correlated information content. There are three types of statistical methods.The first type selects a subset of “best” explanatory variables (view post here). The second type selects a small set of latent background factors of all explanatory variables and then uses these background factors for prediction (Dynamic Factor Models). The third type generates a small set of functions of the original explanatory variables that historically would have retained their explanatory power and then deploys these for forecasting (Sufficient Dimension Reduction).

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Debt-weighted exchange rates

January 28, 2017

Trade-weighted exchange rates help assessing the impact of past currency depreciation on economic growth through the external trade channel. Debt-weighted exchange rates help assessing the impact of past currency depreciation on economic growth through the financial channel. Since these effects are usually opposite looking at both simultaneously is crucial for using exchange rate changes as a predictor of economic and local market performance. For example, as a consequence of the financial channel many EM economies fail to benefit from currency depreciation in the way that small developed economies do.

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Using SVAR for macro trading strategies

January 21, 2017

Structural vector autoregression may be the most practical model class for empirical macroeconomics. Yet, it can also be employed for macro trading strategies, because it helps identifying specific market and macro shocks. For example, SVAR can identify short-term policy, growth or inflation expectation shocks. Once a shock is identified it can be used for trading in two ways. First, one can compare the type of shock implied by markets with the actual news flow and detect fundamental inconsistencies. Second, different types of shocks may entail different types of subsequent asset price dynamics and may, hence, be a basis for systematic strategies.

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Improving asset return forecasts with wavelets

December 23, 2016

Time series that are used for forecasting asset returns can carry information on trends of different persistence. Therefore, frequency decomposition of standard signals based on wavelets can improve and expand potential predictors. Similarly, asset returns can be decomposed into parts of different persistence. These can be forecast separately and summed up eventually. This “sum-of-parts” method seems to improve forecast accuracy because its aligns predictors and return trends and helps separating signal from noise.

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The drivers of commodity cycles

December 17, 2016

Demand shocks have been the dominant force behind non-oil commodity price cycles, according to a 145-year empirical analysis. They have been linked to global recessions or recoveries and displayed persistent effects of 10 years or more. The second most import driver has been so-called “inventory shocks”, which have been less long-lived. Supply shocks have not played an important role in driving long-term price deviations of most commodities. They were mostly commodity-specific and transient.

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