FX forward returns: basic empirical lessons

September 9, 2017

FX forward returns for 29 floating and convertible currencies since 1999 provide important empirical lessons. First, the long-term performance of FX returns has been dependent on economic structure and clearly correlated with forward-implied carry. The carry-return link has weakened considerably in the 2010s. Second, monthly returns for all currencies showed large and frequent outliers beyond the borders of a normal random distribution. Simple volatility targeting would not have mitigated this. Third, despite large fundamental differences, all carry and EM currencies have been positively correlated among themselves and with global risk benchmarks. Fourth, relative standard deviations across currencies have been predictable and partly structural. Hence, they have been important for scaling FX trades across small currencies.

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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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Fear of drawdown

August 19, 2017

Experimental research suggests that probability of outright loss rather than volatility is the key driver of investor risk perceptions. Moreover, fear of drawdown causes significant differences of prices for assets with roughly equal expected returns and standard deviations. Investors forfeit significant expected returns for the sake of not showing an outright loss at the end of the investment period. This suggests that trading strategies with a high probability of outright losses produce superior volatility-adjusted returns. Rational acceptance of regular periodic drawdowns or “bad years” should raise long-term Sharpe ratios.

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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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Predicting asset price correlation for dynamic hedging

July 29, 2017

Dynamic hedging requires prediction of correlations and “betas” across asset classes and contracts. A new paper on dynamic currency hedging proposes two enhancements of traditional regression for this purpose. The first is the use of option-implied volatilities, which are plausibly related to future actual volatility and correlation across assets. The second enhancement is the use of parameter shrinkage in regression estimation (LASSO method), which mitigates the risk of overfitting.

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Global market portfolio: construction and performance

July 22, 2017

A representative market portfolio can be built as the capitalization-weighted average of global equity, real estate and bonds. From 1960 to 2015 such a portfolio would have recorded a dollar-denominated nominal compound return of 8.4%, a real (inflation-adjusted) return of 4.4% and a Sharpe ratio of 0.7. Equity has delivered superior absolute returns, while bonds have delivered superior risk-adjusted returns, consistent with the “low risk effect” theory (view post here). The disinflationary period delivered more than double the returns of the inflationary period. Plausibility and empirical evidence suggest that the market portfolio is not efficient.

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Cross-asset carry: an introduction

July 15, 2017

Carry can be defined as return for unchanged market prices and is easy to calculate in real time across assets. Carry strategies often reap risk premia and implicit subsidies. Historically, they have produced positive returns in FX, commodities, bonds and equity. Carry strategies can also be combined across asset classes to render diversification benefits. Historically, since 1990, the performance of such diversified carry portfolios has been strong, with Sharpe ratios close to 1, limited correlation to benchmark indices and less of a downside skew that FX carry trades.

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Explaining FX forward bias

July 8, 2017

Forward bias in foreign exchange markets means that a positive interest rate differential precedes currency appreciation. It has been an empirical regularity in developed FX markets in recent decades. The forward bias contradicts traditional theory: positive risk-adjusted interest rate differentials are supposed to be offset by expected currency depreciation. An academic paper explains how FX forward bias arises when central banks ‘lean against the wind’ of appreciation through sterilized FX interventions.

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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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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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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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