The predictive power of real government bond yields

September 23, 2023

Real government bond yields are indicators of standard market risk premia and implicit subsidies. They can be estimated by subtracting an estimate of inflation expectations from standard yields. And for credible monetary policy regimes, inflation expectations can be estimated based on concurrent information on recent CPI trends and the future inflation target. For a data panel of developed markets since 2000, real yields have displayed strong predictive power for subsequent monthly and quarterly government bond returns. Simple real yield-based strategies have added material economic value in 2000-2023 by guiding both intertemporal and cross-country risk allocation.

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A model for bond risk premia and the macroeconomy

July 15, 2023

An empirical analysis of the U.S. bond market since the 1960s emphasizes occasional abrupt regime changes, as defined by yield levels, curve slopes, and related volatility metrics. An arbitrage-free bond pricing model illustrates that bond risk premia can be decomposed into two types. One is related to continuous risk factors, traditionally summarized as the level, slope, and curvature of the yield term structure. The other type is related to regime-switching risk. Accounting for regime shift risk adds significant explanatory power to the model. Moreover, risk premia associated with regime shifts are related to the macroeconomic environment, particularly inflation and economic activity. The market price of regime shifts is strongly pro-cyclical and largely explained by these economic indicators. Investors apply a higher regime-related discount to bond values when the economy is booming.

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Equilibrium theory of Treasury yields

May 2, 2020

An equilibrium model for U.S. Treasury yields explains how macroeconomic trends and related expectations for future short-term interest rates shape the yield curve. Long-term yield trends arise from learning about stable components in GDP growth and inflation. They explain the steady rise of Treasury yields in the 1960s-1980s and their decline in the 1990s-2010s. Cyclical movements in yields curves result from learning about transitory deviations of GDP growth and inflation. They explain why curves have been steep out of recessions and inverted in mature economic expansions. Finally, since the 2000s pro-cyclical inflation expectations and fears for secular stagnation have accentuated the steepness of the Treasury curve; positive correlation between inflation and growth expectations means that the Fed can cut rates more drastically to support the economy.

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Analyzing global fixed income markets with tensors

August 24, 2019

Roughly speaking, a tensor is an array (generalization of a matrix) of numbers that transform according to certain rules when the array’s coordinates change. Fixed-income returns across countries can be seen as residing on tensor-like multidimensional data structures. Hence a tensor-valued approach allows identifying common factors behind international yield curves in the same way as principal components analysis identifies key factors behind a local yield curve. Estimated risk factors can be decomposed into two parallel risk domains, the maturity domain, and the country domain. This achieves a significant reduction in the number of parameters required to fully describe the international investment universe.

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The duration extraction effect

April 13, 2019

Under non-conventional monetary policy central banks influence financial markets through the “portfolio rebalancing channel”. The purchase of assets changes the structure of prices. A particularly powerful portfolio rebalancing effect arises from duration extraction, i.e. the combined size expansion and duration extension of the assets that have been absorbed onto the central bank’s balance sheet. Duration extraction has a significant and persistent impact on the yield curve and the exchange rate. Importantly, the effect arises from hints or announcements of new parameters for the future stock of assets. Given the large size of central bank balance sheets, this explains why changes in expected asset purchases, re-investments or redemption plans have a profound impact on financial markets.

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Understanding the correlation of equity and bond returns

December 1, 2018

The correlation of equity and high grade sovereign bond returns is a powerful driver of portfolio construction and the term premia of interest rates. This correlation has turned from positive in the 1970s-1990s to negative in the 2000s-2010s, on the back of similar shifts in the correlation between inflation and economic growth and between inflation and real interest rates. The structural correlation flip has given rise to a risk parity investment boom and contributed to the compression in long-term yields. Both theoretical and empirical analysis suggests that negative equity-bond correlation is due largely to pro-cyclical inflation, i.e. higher inflation coinciding with better economic performance, as opposed counter-cyclical inflation or stagflation. Inflation is more likely to be pro-cyclical if it is low or in deflation (view post here) and driven by demand rather than supply shocks.

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How convenience yields have compressed real interest rates

November 3, 2018

Real interest rates on ‘safe’ assets such as high-quality government bonds had been stationary around 2% for more than a century until the 1980s. Since then they have witnessed an unprecedented global decline, with most developed markets converging on the U.S. market trend. There is evidence that this trend decline and convergence of real rates has been due prominently to rising convenience yields of safe assets, i.e. greater willingness to pay up for  safety and liquidity. This finding resonates with the historic surge in official foreign exchange reserves, the rising demand for high-quality liquid assets for securitized transactions and the preferential treatment of government bonds in capital and liquidity regulation (view previous post here).

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Multiple risk-free interest rates

October 6, 2018

Financial markets produce more than one risk-free interest rate. This is because there are several separate market segments where structured trades replicate such a rate. Differences in remuneration arise for two reasons. First, financial frictions can prevent arbitrage. Second, some risk-free assets pay additional convenient yields, typically by virtue of their liquidity and suitability as collateral. Put simply some “safe assets” have value beyond return. U.S. government bonds, in particular, seem to provide a sizable consistent convenience yield that tends to soar in crisis. This suggests that there are arbitrage opportunities for investors that are flexible, impervious to convenience yields and tolerant towards temporary mark-to-market losses.

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Term premia and macro factors

June 30, 2018

The fixed income term premium is the difference between the yield of a longer-maturity bond and the average expected risk-free short-term rate for that maturity. Abstractly, it is a price for commitment. The term premium is not directly observable but needs to be estimated based on the assumptions of a term structure model that separates expected short-term rates and risk premia. Model assumptions become a lot more realistic if one includes macroeconomic variables. In particular, long-term inflation expectations plausibly shape the long-term trend in yield levels. Also cyclical fluctuations in inflation and unemployment explain slope and curvature to some extent. A recent IMF paper proposes a methodology for integrating macroeconomic variables in a conventional affine term structure model.

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Fixed income carry as trading signal

April 28, 2018

Empirical evidence for 27 markets suggests that carry on interest rate swaps has been positively correlated with subsequent returns for the past two decades. Indeed, a naïve strategy following carry as signal has produced respectable risk-adjusted returns. However, this positive past performance masks the fundamental flaw of the carry signal: it disregards the expected future drift in interest rates and favours receiver position in markets with very low real rates. In the 2000s and 2010s this oversight mattered little because inflation and yields drifted broadly lower. If the inflation cycle turns or just stabilizes, however, short-term rates normalization should become very consequential. Indeed, enhancing the IRS carry signal by a plausible medium term drift in short rates has already in the past produced more stable returns and more convincing actual “alpha”.

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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 over eighteen years. 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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