Conditional short-term trend signals

January 18, 2025

Jupyter Notebook

There are plausible relations between past and future short-term trends across and within financial markets. This is because market returns affect expected physical payoffs, risk premia, and the monetary policy outlook. However, the relations between past and future returns are unstable and often depend on the economic environment. As an example, this post shows that the impact of short-term commodity future trends on subsequent S&P500 future returns depends on the inflationary pressure in the U.S. economy. Empirical analysis suggests that macro-conditional trend signals outperform unconditional short-term trend signals regarding predictive power, accuracy and naïve PnL generations.

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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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Inflation expectations and interest rate swap returns

August 20, 2022

Inflation expectations wield great influence over fixed income returns. They determine the nominal yield required for a given equilibrium real interest rate, they influence inflation risk premia, and they shape the central bank’s course of action. There is no uniform inflation expectation metric than can be tracked in real-time. However, there are useful and complementary proxies, such as market-based breakeven inflation and economic data-based estimates. For trading strategies, these two can be combined. The advantage of breakeven rates is the real-time tracking of a broad range of influences. The advantages of economic data-based estimates are clarity, transparency, and precision of measurement. Changes in both inflation metrics help predict interest rate swap returns, but their combination is a better predictor than the individual series, emphasizing the complementarity of market and economic data.

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Equity values and credit spreads: the inflation effect

December 29, 2018

A theoretical paper shows that a downward shift in expected inflation increases equity valuations and credit default risk at the same time. The reason for this is “nominal stickiness”. A slowdown in consumer prices reduces short-term interest rates but does not immediately reduce earnings growth by the same rate, thus increasing the discounted present value of future earnings. At the same time, a downward shift in expected inflation increases future real debt service and leverage of firms and increases their probability of default. This theory is supported by the trends in U.S. markets since 1970. It would principally argue for strategic relative equity-CDS positions inversely to the broad trend in expected inflation.

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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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The “de-anchoring” of inflation in the euro area

April 16, 2016

Two recent empirical studies highlight the risk that inflation expectations in the euro area are becoming de-anchored, similar to Japan. De-anchoring means that short-term price shocks can change long-term expectations. Importantly, the papers suggest medium- and short-term measures to track this de-anchoring. De-anchoring increases the risk of actual deflation and may add to the risk premia on equity and credit.

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What we can learn from the “fiscal theory of inflation”

February 13, 2016

Fiscal policy is as important as monetary policy for inflation dynamics. Government debt has features similar to money and affects private wealth and prices. In particular, if monetary policy protects debt sustainability expansionary fiscal policy is inflationary and restrictive fiscal policy is dis-inflationary or deflationary. Moreover, high interest rates are inflationary and low interest rates are deflationary.

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The deflationary bias of low interest rates

July 12, 2015

Compressed interest rates raise the risk of hitting the zero lower bound. A new theoretical ECB paper shows that even before the ZLB is reached this creates a deflationary bias, as inflation expectations shift lower, real rates rise, and consumption and pricing power decline. To counter this bias central banks would need to accept positive output gaps (tighter labour markets) or even increase their inflation targets.

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Forecasting inflation under globalisation

June 20, 2015

Two recent papers contribute to forecasting inflation in a world of convergent policy regimes and integrated economies. The first emphasizes the distinct effects of shocks to aggregate demand, supply, and monetary policy. The second explains why country inflation usually corrects deviations from trends in the rest of the world. Predominantly inflation has become a global force.

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The four components of long-term bond yields

May 23, 2015

A BOJ paper proposes an affine terms structure model for bond yields under consideration of the zero lower bound. It estimates the contribution of [i] expected real rates, [ii] real term premia, [iii] expected inflation rates, and [iv] inflation risk premia. In the U.S. yields have been driven mainly by expected real rates and real term premia in recent years. In Japan inflation expectations and inflation/deflation risk premia have played a greater role.

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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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