Terms of trade as FX trading signal

April 10, 2023

All other things equal, an improvement in a country’s terms of trade, the ratio of export to import prices, translates into increased demand for its currency and a boost for its growth outlook. However, terms of trade are a rather subtle and sporadic influence. Therefore, many market participants are rationally inattentive to smaller changes and unwilling to trade on large changes in times of turmoil. This points to investor value in the systematic consideration of monthly or annual terms-of-trade dynamics, which can be approximated by commodity-based export and import price indices. Empirically, standard terms-of-trade dynamics have indeed predicted FX returns positively since 2000, across developed and emerging market countries. However, while this relation has been fairly stable in the developed world since 2000, for emerging markets the trading value of terms-of-trade indicators has only become evident since the great financial crisis.

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Excess inflation and asset class returns

March 25, 2023

Jupyter Notebook

Excess inflation means consumer price trends over and above the inflation target. In a credible inflation targeting regime, positive excess inflation skews the balance of risks of monetary policy towards tightening. An inflation shortfall tips the risk balance towards easing. Assuming that these shifting balances are not always fully priced by the market, excess inflation in a local currency area should negatively predict local rates market and equity market returns, and positively local-currency FX returns. Indeed, these hypotheses are strongly supported by empirical evidence for 10 developed markets since 2000. For fixed income and FX excess inflation has not just been a directional but also a relative cross-country trading signal. The deployment of excess inflation as a trading signal across asset classes has added notable economic value.

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Convenience yield risk premia

March 11, 2023

The convenience yield of a commodity is the benefit that arises from physical access. In conjunction with storage costs, it wields great influence on the slope of the futures curve. On its own, a high convenience yield translates into backwardated futures curves and positive carry. Different sections of the commodity curve contain different implied convenience yields. A new paper proposes a measure of convenience yield risk, based on the difference in volatility of convenience yields implied by the front and subsequent section of the curve. Panel regression for 27 commodities and nearly 60 years suggests that the convenience yield risk signal positively predicts commodity returns, similar to the predictive power of dividend growth volatility for equity returns. A convenience yield risk-based trading signal seems to have added significant investor value.

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Predicting base metal futures returns with economic data

February 25, 2023

Unlike other derivatives markets, for commodity futures, there is a direct relation between economic activity and demand for the underlying assets. Data on industrial production and inventory build-ups indicate whether recent past demand for industrial commodities has been excessive or repressed. This helps to spot temporary price exaggerations. Moreover, changes in manufacturing sentiment should help predict turning points in demand. Empirical evidence based on real-time U.S. data and base metal futures returns confirms these effects. Simple strategies based on a composite score of inventory dynamics, past industry growth, and industry mood swings would have consistently added value to a commodities portfolio over the past 28 years, without adding aggregate commodity exposure or correlation with the broader (equity) market.

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Testing macro trading factors

February 11, 2023

The recorded history of modern financial markets and macroeconomic developments is limited. Hence, statistical analysis of macro trading factors often relies on panels, sets of time series across different currency areas. However, country experiences are not independent and subject to common factors. Simply stacking data can lead to “pseudo-replication” and overestimated significance of correlation. A better method is to check significance through panel regression models with period-specific random effects. This technique adjusts targets and features of the predictive regression for common (global) influences. The stronger these global effects, the greater the weight of deviations from the period-mean in the regression. In the presence of dominant global effects, the test for the significance of a macro factor would rely mainly upon its ability to explain cross-sectional target differences. Conveniently, the method automatically accounts for the similarity of experiences across markets when assessing the significance and, hence, can be applied to a wide variety of target returns and features. Examples show that the random effects method can deliver a quite different and more plausible assessment of macro factor significance than simplistic statistics based on pooled data.

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Fiscal policy criteria for fixed-income allocation

January 28, 2023

Jupyter Notebook

The fiscal stance of governments can be a powerful force in local fixed-income markets. On its own, an expansionary stance is seen as a headwind for long-duration or government bond positions due to increased debt issuance, greater default or inflation risk, and less need for monetary policy stimulus. Quantamental indicators of general government balances and estimated fiscal stimulus allow backtesting the impact of fiscal stance information. Empirical evidence for 20 countries since the early 2000s shows that returns on interest rate swap receiver positions in fiscally more expansionary countries have significantly underperformed those in fiscally more conservative countries. Indicators of fiscal stance have been timely, theoretically plausible, and profitable criteria for fixed-income allocations across currency areas.

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Detecting trends and mean reversion with the Hurst exponent

January 14, 2023

The Hurst exponent is a statistical measure of long-term memory of time series. The existence and form of such memory are of great interest in financial markets, as financial returns are not generally governed by random walks.
The Hurst exponent is a single scalar value that indicates if a time series is purely random, trending, or rather mean reverting. Thus, it can validate either momentum or mean-reverting strategies. The Hurst exponent uses the variance of a log price series to assess the rate of diffusive behavior. If a time series follows a random walk, its variance simply increases linearly with time elapsed. If instead variance increases with time to the power of an exponent, then a low (Hurst) exponent would indicate mean reversion and a high exponent trending behavior. The Hurst exponent depends on the period used for return calculation. For example, monthly returns can display a memory that is different from daily returns.
The Hurst exponent is estimated rather than calculated. Most methods regress rescaled ranges of the return series on the time span of observations. Code examples are available for Python and R.

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Modified and balanced FX carry

December 31, 2022

Jupyter Notebook

There are two simple ways to enhance FX carry strategies with economic information. The first increases or reduces the carry signal depending on whether relevant economic indicators reinforce or contradict its direction. The output can be called “modified carry”. It is a gentle adjustment that leaves the basic characteristics of the original carry strategy intact. The second method equalizes the influence of carry and economic indicators, thus diversifying over signals with complementary strengths. The combined signal can be called “balanced carry”. An empirical analysis of carry modification and balancing with economic performance indicators for 26 countries since 2000 suggests that both adjustments would have greatly improved the performance of vol-targeted carry strategies. Modified carry would also have improved the performance of hedged FX carry strategies.

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FX trades after volatility shocks

December 10, 2022

Currency areas with negative external balances are – all other things equal – more vulnerable to financing shocks. Jumps in market price volatility often indicate such shocks. Realistically it takes a few days for the market to fully price the consequences of shocks consistently across currencies. Hence, the products of external balances-based “resilience scores” and volatility shocks are plausible indicators of “post-shock currency hazards”. This means that they should serve as signals for differences in currency returns after market volatility has surged or dropped. An empirical analysis based on 28 currencies since 2000 shows that a most simple “post-shock currency hazard” measure has significantly helped predict subsequent short-term returns and would have added positive PnL to FX trading strategies, particularly in times of turbulence.

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Identifying the drivers of the commodity market

November 26, 2022

Commodity futures returns are correlated across many different raw materials and products. Research has identified various types of factors behind this commonality: [i] macroeconomic changes, [ii]  financial market trends, and [iii] shifts in general uncertainty. A new paper proposes to estimate the strength and time horizon of these influences through mixed-frequency vector autoregression. Mixed-frequency Granger causality tests can assess the interaction of monthly, weekly, and daily data without aggregating to the lowest common frequency and losing information. An empirical analysis for 37 commodity futures from all major sectors, based on mixed-frequency Granger causality tests,  suggests that macroeconomic changes are the dominant common driver of monthly commodity returns, while financial market variables exercise commanding influence at a daily frequency.

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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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