LMEprecious - Joining the futures world?

Any managed futures trader will tell you that trading metals on the LME is much more difficult than other "futures" contracts. Structural differences make for a more challenging environment from monitoring and capital usage to transaction costs. The continuous forward contracts of the LME are just more difficult to trade than the focused discrete delivery dates of futures because market liquidity is spread over a wider set of dates. Even if liquidity is centered at a three month prompt, the liquidity on exit before expiration may be more difficult to find. 

This liquidity difficulty may be offset by the greater flexibility in contract expirations at the LME versus a futures contract. Hence, hedgers may find the LME a more attractive alternative than the traditional futures contracts which have greater basis risk from the limited contracts expirations. Speculators, on the other hand, who place a premium on liquidity and consolidation of order flow will find futures contracts more appealing. Nevertheless, it always becomes an issue of networking. Pardon the language, but traders trade where others trade. However, for speculators, there always is a choice of just avoiding markets that are more costly and difficult to trade which hurts overall liquidity and development. Market design matters. 

These costs and issues show up in the convenience yield for different market participants. The convenience yield embedded within the futures price includes the cost of transacting but creates noise in the price discovery from the full cost of carry relationship. The convenience yield associated with using LME is higher for hedger because they can hold a forward that matches their industrial needs.  The convenience yield for speculators is lower because the round-trip cost and uncertainty of liquidity is higher. Contract and market design has to be structured to minimize the dispersion in convenience yield to allow for maximum price discovery and minimum basis risk. 

The reason for this discussion is that the LME will be offering new gold and silver contracts called LMEprecious that will have most of the characteristics of a traditional futures contracts and will not take the traditional form LME forward contracts. The LME has introduced other forward contracts that are more futures-like to consolidate liquidity and trading at specific points through their third Wednesday contracts. 

The new LMEprecious contacts for gold and silver when they launch in June, will be subject to the same difficulties of most new futures contracts. New contracts will normally be relegated to failure with an occasional success. The success or failure of the futures contract will be based on its ability to gain a network and scale with liquidity and trading. If there is no liquidity, the trading convenience yield will be outside the range of other comparable futures contract with no mechanism for arbitrage, a market failure. However, the LME is doing more than most to help with success of these contracts. From the World Gold Council to selected dealer banks, the LME has attempted to solve the network problem on day one.

The gold market is especially crowded with alternative markets structures, in New York, Shanghai, and the host of OTC alternatives. Any gold contact has to overcome three structural issues: geography, (the market is moving east); clearing (the market is moving to centralized clearing and away from OTC), and liquidity (the market will always seek the highest liquidity place for trading). However, some strong trading backers, centralized clearing and the new regulatory regime may give LMEprecious a good chance for survival and a meaningful share of the gold trade.

Trends and break-outs - No strong directions for any sectors

For most managed futures managers, the modeling task is simple, look for trends or break-outs. Managers are not predictive but reactive to what market prices are doing. Looking at the current price data across the major sectors provide little evidence of strong trends or break-outs. Trends that seem to be currently developing are not strong enough to move beyond recent highs, so our trend sector matrix is showing sideways to a slight up moves across most sectors with the only strong trends in commodity markets. 

These sideways indications do not mean that there won't be strong trends in April. It just says that trends at the end of the month were limited and any extrapolation will suggest limited returns. There were a number of strong trend reversals upon the FOMC announcement of a rate hike in mid-March. This central bank action and commentary arrested moves in currencies, fixed income, and rates especially within the US. The best trends may be in non-US global stock indices and fixed income. 

The signals from price tells us the positive sentiment trades for Trump policies are being reassessed with non-US markets moving to a growth reflation story albeit one that is still modest by comparisons with the past. Generally, the markets have lost a clear direction from the macroeconomic environment. Commodity signals tell us that supply imbalances still exist and the work-off of inventories will take some time as long there are no surprise demand shocks. 

We may be surprised later in the month, but April returns currently will have limited tailwinds from March trends that could drive managed futures performance. 

Strong non-US returns for the quarter - end of the Trump effect?

The capital flows and returns for the month and quarter tell a risk-on story for global markets. This is not the case for the US where equity returns were at best flat and bonds showed negative returns in March. The dollar sold off for the month by slightly less than one percent as measured by the DXY dollar index. Even if we account for the dollar tailwind for international stocks, global equities did better than the US by well over 2% for March. Emerging markets have seen the best quarter in years with double-digit returns. Adjusting for the dollar would have placed international and emerging market bonds in-line with US bond returns. 

We are a long way from the threat of a global slowdown based on trade wars. Similarly, we are a long way from the early Trump rally in US equities driven by bold tax reform and fiscal stimulus programs. All tax reforms have always taken longer than expected and there is no special magic with the current Trump administration at moving an agenda. Similarly, we have seen the problems with moving "shovel-ready" projects through Congress. Spending programs such as infrastructure development take time to move through the legislative process. Hence, the euphoric sentiment in US stocks has been tempered and the value for non-US markets has taken on new life with the higher expectations for global growth.

Fixed income has fallen in-line with a higher global growth story, stronger inflation numbers, and a Fed that is tightening faster than expected earlier in the quarter. The numbers tell us that we are close to optimal targeting for unemployment and inflation. Inflation itself, as measured by the latest PCE inflation index numbers, is closing in or around 2% but does not seem to be in an overshoot mode. Hence, bonds have not seen a large sell-off in March and still showed positive returns for the quarter. The outlier on the downside has been commodities which sold-off in many key markets. 

Using financial conditions to see when crisis alpha is needed

Financial conditions can inform us about periods when there will be crises and market dislocations. The graph above shows the time series for the Chicago Fed adjusted financial conditions index. The index measures liquidity, risk, and leverage in money, debt and equity markets as well as measures of traditional and shadowing banking. If the index is positive (negative), financial conditions are looser (tighter) than average. A close look will suggest that when financial conditions are tight corresponds to periods when there has been a crisis. Generally, these have been period when the markets are moving to or in a risk-off regime. The change in financial conditions tells us something about transition in markets. If the index is moving from negative to positive, financial conditions are tightening. A decline in the index suggests that financial conditions are deteriorating.

During these periods of transition, divergent strategies such as managed futures should do better than other periods when financial conditions are good and there is a risk-on regime. In particular, we are looking to see if tightening or deteriorating financial conditions are periods when managed futures do better than average.

We have conducted some simple statistical analysis and found that what may seem obvious on a graph may actually be harder to find when looking closely at the data. We divided financial conditions into subsets based on whether the index was positive or negative and either moving higher or lower. We then compared these periods with the subsequent three-month returns for the BTOP 50 managed futures CTA index. We find that whether financial conditions are positive or negative does not really matter, but the change in the financial conditions does matter. If financial conditions are deteriorating, then subsequent BTOP index returns will be stronger than non-deteriorating periods and the average three-month return. However, there is little difference in managed futures returns during periods when financial conditions are loosening. Tightening of financial conditions lead to more market divergences. Unfortunately, a simple test for significant will find that these are not significantly different from average at anywhere close to 90% confidence. 

Right now, financial conditions seem to be looser than normal and not at all tightening. By this description of the market, managed futures returns as measured by the largest managers who are usually trend-followers will fall into a normal range.