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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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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The “low risk effect” in financial markets

May 27, 2017

Low-beta and low-volatility securities can produce superior risk-adjusted returns. Thus, portfolios of calibrated low- versus high-vol stock positions have historically generated significant alpha. Other asset classes display similar ‘low risk effects’. Their plausible cause is many investors’ limited access to leverage and willingness to pay a premium for securities with greater exposure to market performance. Some investors may also pay a premium for lottery-like payoffs with large upside potential. For leveraged portfolio managers this creates relative value opportunities in form of ‘betting against market correlation’ or ‘betting against volatility’.

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Explosive dynamics in exchange rates

May 20, 2017

Explosiveness in financial markets means that prices display exponential growth. In recent years statistical tests have been developed to locate mildly explosive bubble periods in real time. In conjunction with judgment on underlying fundamentals they help detecting price distortions. A new paper shows how tests for explosiveness can be applied to exchange rates. The tests suggest that developed market currencies have recurrently experienced episodes of explosive behaviour, reaching from a few days to up to three months. Currency level changes seem to reverse subsequently. Periods of explosiveness since 2000 have often been related to the U.S. dollar and financial market volatility.

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Understanding negative inflation risk premia

May 13, 2017

Inflation risk premia in the U.S. and the euro area have disappeared or even turned negative since the great financial crisis, according to various studies. There is also evidence that this is not because inflation uncertainty has declined but because the balance of risk has shifted from high inflation problems to deflationary recessions. Put simply, markets pay a premium for bonds and interest rate swap receivers as hedge against deflation risk rather than demanding a discount for exposure to high inflation risk. This can hold for as long as the expected correlation between economic-financial performance and inflation remains broadly positive.

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Volatility risk premia in the commodity space

May 6, 2017

Volatility risk premia – differences between options-implied and actual volatility – are valid predictors for risky asset returns. High premia typically indicate high surcharges for the risk of changes in volatility, which are paid by investors with strong preference for more stable returns. For commodities volatility risk premia should have become a greater factor as consequence of their “financialization”. New evidence suggests that indeed volatility risk premia on commodity currencies have predictive power for subsequent commodity returns, while crude and gold premia have predictive power for other asset classes in accordance with the nature of these commodities. Since estimation of these premia takes some skill and judgment this points to opportunities for macro trading with econometric support.

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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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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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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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