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.