Reported economic changes and the Treasury market: impact and payback

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Financial markets pay great attention to reported changes in key economic statistics, particularly when they are unexpected. For quantitative analysis, we introduce the concept of information state changes and the methods of aggregating them across time and indicators. We apply these to a few popular U.S. indicators and investigate how information state changes have affected the bond market. In line with theory, monthly changes in economic growth, inflation, and employment growth have all been negatively correlated with concurrent Treasury returns over the past 25 years. However, there has been subsequent payback: the correlation reverses for subsequent monthly Treasury returns. This supports the hypothesis that high publicity volatile indicators are easily “overtraded.” Cognitive biases may systematically exaggerate positioning toward the latest “surprises” or publicized changes.

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Inventory scores and metal futures returns

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Inventory scores are quantamental (point-in-time) indicators of the inventory states and dynamics of economies or commodity sectors. Inventory scores plausibly predict base metal futures returns due to two effects. First, they influence the convenience yield of a metal and the discount at which futures are trading relative to physical stock. Second, they predict demand changes for restocking by producers and industrial consumers. Inventory scores are available for finished manufacturing goods and base metals themselves. An empirical analysis for 2000-2024 shows the strong predictive power of finished goods inventory scores and some modest additional predictive power of commodity-specific inventory scores.

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Equity market timing: the value of consumption data

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The dividend discount model suggests that stock prices are negatively related to expected real interest rates and positively to earnings growth. The economic position of households or consumers influences both. Consumer strength spurs demand and exerts price pressure, thus pushing up real policy rate expectations. Meanwhile, tight labor markets and high wage growth shift national income from capital to labor.
This post calculates a point-in-time score of consumer strength for 16 countries over almost three decades based on excess private consumption growth, import trends, wage growth, unemployment rates, and employment gains. This consumer strength score and most of its constituents displayed highly significant negative predictive power with regard to equity index returns. Value generation in a simple equity timing model has been material, albeit concentrated on business cycles’ early and late stages.

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Pure macro FX strategies: the benefits of double diversification

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Pure macro(economic) strategies are trading rules that are informed by macroeconomic indicators alone. They are rarer and require greater analytical resources than standard price-based strategies. However, they are also more suitable for pure alpha generation. This post investigates a pure macro strategy for FX forward trading across developed and emerging countries based on an “external strength score” considering economic growth, external balances, and terms-of-trade.

Rather than optimizing, we build trading signals based on the principles of “risk parity” and “double diversification.” Risk parity means that allocation is adjusted for the volatility of signals and returns. Double diversification means risk is spread over different currency areas and conceptual macro factors. Risk parity across currency signals diminishes vulnerability to idiosyncratic country risk. Risk parity across macroeconomic concepts mitigates the effects of the seasonality of macro influences. Based on these principles, the simplest pure macro FX strategy would have produced a long-term Sharpe ratio of around 0.8 before transaction costs with no correlation to equity, fixed income, and FX benchmarks.

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A model for bond risk premia and the macroeconomy

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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Equity trend following and macro headwinds

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Market price trends often foster economic trends that eventually oppose them. Theory and empirical evidence support this phenomenon for equity markets and suggest that macro headwind (or tailwind) indicators are powerful modifiers of trend following strategies. As a simple example, we calculate a macro support factor for equity index futures in the eight largest developed markets based on labor markets, inflation, and equity carry. This factor is used to modify standard trend following signals. The modification increases the predictive power of the trend signal and roughly doubles the risk-adjusted return of a stylized global trend following strategy since 2000.

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Merchandise import as predictor of duration returns

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Local-currency import growth is a widely underestimated and important indicator of trends in fixed-income markets. Its predictive power reflects its alignment with economic trends that matter for monetary policy: domestic demand, inflation, and effective currency dynamics. Empirical evidence confirms that import growth has significantly predicted outright duration returns, curve position returns, and cross-currency relative duration returns over the past 22 years. A composite import score would have added considerable economic value to a duration portfolio through timing directional exposure, positioning along the curve, and cross-country allocations.

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FX trend following and macro headwinds

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Trend following can benefit from consideration of macro trends. One reason is that macroeconomic data indicate headwinds (or tailwinds) for the continuation of market price trends. This is particularly obvious in the foreign-exchange space. For example, the positive return trend of a currency is less likely to be sustained if concurrent economic data signal a deterioration in the competitiveness of the local economy. Macro indicators of such setback risk can slip through the net of statistical detection of return predictors because their effects compete with dominant trends and are often non-linear and concentrated. As a simple example, empirical evidence shows that standard global FX trend following would have benefited significantly merely from adjusting for changes in external balances.

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Macroeconomic cycles and asset class returns

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Indicators of growth and inflation cycles are plausible and successful predictors of asset class returns. For proof of concept, we propose a single balanced “cyclical strength score” based on point-in-time quantamental indicators of excess GDP growth, labor market tightening, and excess inflation. It has clear theoretical implications for all major asset markets, as rising operating rates and consumer price pressure raise real discount factors. Empirically, the cyclical strength score has displayed significant predictive power for equity, FX, and fixed income returns, as well as relative asset class positions. The direction of relationships has been in accordance with standard economic theory. Predictive power can be explained by rational inattention. Naïve PnLs based on cyclical strength scores have each produced long-term Sharpe ratios between 0.4 and 1 with little correlation with risk benchmarks. This suggests that a single indicator of cyclical economic strength can be the basis of a diversified portfolio.

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Predicting base metal futures returns with economic data

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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