Short-term trend trading and liquidity - stay away from small tick contracts

 

The paper, “Is Trend Still Your Friend: A microstructural account of the demise of short-term trend-following”, is important research on why trend-following may not work over short horizons. While trend-following seems to span time, there are exceptions. Since 2009, there has been no profit to be had from short-term trend trading. This paper documents the break in short-term trend trading and finds a reasonable explanation. 

The paper tests four different explanations: 1. capacity constraints, 2. market electrification, 3. a change in CTA order flow interactions, and 4. microstructural changes. The authors find that the first three cannot explain the differences, but the volatility-normalized tick size can explain the change in profits. The trend profits fell on small-tick contracts but remain intact for large-tick contracts. Trend signals trigger directional trades. The market impact of these trades reinforces price movement. This feedback loop requires aggressive execution at reasonable costs, but it also causes market makers to withdraw from the trend, especially for small-tick contracts. Trend-following becomes unprofitable. Stick with the large ticks if you want to trade short-term. 

Japan and the big carry trade

 

The yen carry trade has existed for decades. Borrow in cheap Japanese funding markets, sell yen, and then buy the currency of a high-yielding market in some other currency. Of course, hedging and risk management add layers, but the overall strategy is straightforward. Everything works until it does not, because of two things: 1) rates in Japan increase relative to the rest of the world, the yield spread falls; and 2) the yen appreciates, which can wipe out the gains from the spread differential. Now the Bank of Japan is raising rates, and the Finance Ministry is intervening in the yen markets to stop the currency slide. The net effect. is that less money will flow into foreign-yielding markets versus Japan. This will mean global rates will adjust higher.

Global bond markets are changing, and old sources of funding will no longer be available to borrowers. We can expect higher equilibrium real rates. We cannot say what the new rates will be, but the old environment is not working. 

Hedge funds and Treasuries - An unholy alliance

 

This may seem obvious, but hedge funds dominate a significant portion of Treasury trading. Their exposure exceeds that of mutual funds, and their behavior strongly affects market direction. These are not the same bond vigilantes of long ago, but a breed of arbitrageurs and directional traders ready to go long or short based on small market deviations. They are both liquidity takers and makers. Their turnover is significant, and they use substantial financing.

You have to ask: what happens if they change their strategies, or if losses elsewhere in their portfolio lead to deleveraging? Treasury prices are unlikely to rise, and liquidity will decline. Regulators have little to do. Do you want hedge funds to leave the market? Data from Decomposing Hedge Funds’ U.S. Treasury Exposures.

Big losses - big mistakes in finance from leverage

 

There are some common themes when it comes to large losses in finance - leverage kills. We cannot say that it is always the case, but a review of the biggest trading losses seems linked to excess leverage. Too much risk with a surprise event, and you have a recipe for losses. This will happen with funds and financials, and if we dig into corporate losses, we will find a link to leverage. What is surprising is that we haven’t had more large losses, given the spike in rates after the long period of low rates. 

We need risk management to protect ourselves from our leveraged behavior.