Macro Momentum as an extension of trend-following?

Trend-following is a price-based system, but that does not mean that trends only occur with prices or can only be exploited through prices. The underlying economic factors that drive prices can also have trends. These macro trends are what often drive price trends. Any price trend will usually be associated with trends in the underlying drivers of markets. 

If the Fed is following a policy of monetary tightening, bonds prices will usually fall. When the Fed is following a dovish policy of lowering the rates the trend in bond prices will move higher. If there is a supply shock to the oil markets, oil prices will rise. If there is stronger economic growth, the price of risky assets will increase. Similarly, an increase in risk sentiment will increase demand for risky assets. 

The macro link may not be perfect and prices trends can often be driven by short-term market dynamics, but a macro momentum model can be an effective way of trading the markets. This is the foundation for a paper from the folks at AQR, "A Half Century of Macro Momentum". Macro momentum can be another way to play market trends.

The macro momentum approached outlined in this paper is fairly simple although the actual implementation may be more difficult than a classic price-based system. Macro momentum can be broken into four different categories: the business cycle (increasing growth or increasing inflation), international trade, monetary policy, and risk sentiment. The trend in each of these macro factors have well-defined impact on markets which can be exploited. 

Increasing growth will serve equity and currency markets while it will be negative for long and short-term bonds. The impact of rising inflation will be positive for currencies although it the change in inflation forecast is at odds with classic PPP theory. Rising inflation will be negative for equities and rates. An increase in trade competitiveness will increase demand for equity indices but have a negative impact on bonds. Monetary policy tightening will be negative for all major asset classes except currencies. An improvement in risk sentiment is positive for currencies and equity indices and negative for bonds, the safe asset.

Macro momentum can be structured as either long/short through cross-sectional analysis or long directional portfolios and can be compared with trend-following portfolios. The response during drawdowns (tail events) will be different. These macro factors can proxy for what many macro managers do. 

Macro momentum is a simple way to incorporate macro themes within a portfolio based on fundamentals ideas concerning trends. Markets will often under-react to new information so following the trends in macro factors will lead to price trends that can be exploited. This is a good middle ground for incorporating the macro narrative with trend-following.