How to use financial conditions indices

October 14, 2017

There are two ways to use financial conditions indicators for macro trading. First, the tightening of aggregate financial conditions helps forecasting macroeconomic dynamics and policy responses. Second, financial vulnerability indicators, such as leverage and credit aggregates, help predicting the impact of an initial adverse shock to growth or financial markets on the subsequent macroeconomic and market dynamics. The latest IMF Global Financial Report has provided some clues as to how to combine these effects with existing economic-financial data.

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The latent factors behind commodity price indices

October 7, 2017

A 35-year empirical study suggests that about one third of the monthly changes in a broad commodity price index can be attributed to a single global factor that is related to the business cycle. In fact, for a non-fuel commodity basket almost 70% of price changes can be explained by this factor. By contrast, oil and energy price indices have been driven mainly by a fuels-specific factor that is conventionally associated with supply shocks. Short-term price changes of individual commodities depend more on contract-specific events, but also display a significant influence of global and sectoral factors. The latent global factor seems to help forecasting commodity index prices at shorter horizons.

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Hedging FX trades against unwanted risk

September 23, 2017

When FX forward positions express views on country-specific developments one can shape the trade to its rationale by hedging against significant unrelated global influences. Almost all major exchange rates are sensitive to directional global market moves and USD-based exchange rates are typically also exposed to EURUSD changes. A simple empirical analysis for 29 currencies for 1999-2017 suggests that the largest part of these influences has been predictable out-of-sample and hence “hedgeable”. Even volatility-adjusted relative positions across EM or FX carry currencies may sometimes be hedged against market directional influences.

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Treasury yield curve and macro trends

September 2, 2017

There is a strong logical and empirical link between the U.S. Treasury yield curve and long-term economic trends, particularly expected inflation and the equilibrium short-term real interest rate. Accounting for variations in these two trends allows isolating cyclical factors in a non-arbitrage term structure model. Put simply, interest rates mean-revert to a ‘shifting endpoint’ that is driven by macroeconomics. According to new research, term structure models that include long-term macro trends substantially improve yield forecasts for the medium term as well as predictions of bond excess returns.

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The demographic compression of interest rates

August 5, 2017

Declining population growth and rising dependency ratios in the developed world have been one key factor behind the decline in nominal and real interest rates since the 1980s. Personal savings for retirement are growing, while investment spending is not rising commensurately, and long-term economic growth is dampened by slowing or even shrinking work forces. A new ECB paper suggests that for the euro area these trends will likely continue to compress interest rates for another 10 years, a challenge for monetary policy and financial stability.

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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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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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