Fed balance sheet - More work to do

The issue that has been important to Fed Chairman Warsh has been the Fed balance sheet. There still isn't enough focus on the dynamics of changes in the balance sheet, inflation, and credit. Total Fed assets are still more than 6 times higher than before the Great Financial Crisis, which was well over 15 years ago. Now, Fed regulatory rules have changed, so the total assets may be much higher for a normal state, but what is the proper number is still. not clear. We do know that over $8 trillion is too high, and more than 25% of GDP is also too high; yet, given inflation is still above target, we should see the balance sheet reduced further. The RMP program is going to zero, which will take out the small blip in 2026, but there is more work. Mortgages will roll off slowly given the low prepayment rates, but that is only a small portion, and the Fed is currently buying bills with the cash flow. There is reluctance to sell Treasuries given the Treasury's strong financing needs. 

To solve the inflation issue, the Fed will need to further reduce its balance sheet.  

 

Peter Lynch on stop-loss

Selling your winners and holding your losers is like cutting the flowers and watering the weeds - Peter Lynch 

Peter Lynch was not a quant or a trend-follower, so it may seem odd that he is talking about trend-following fundamentals, yet the premise of Lynch's argument is clear even for fundamental investors. Hold your good companies and get rid of the bad ones. This does not always have to be based on price. It may just be related to the underlying firm characteristics. However, the thought is always the same. Rid yourself quickly of those weeds and tend to your flowers.

The types of trend-following systems - choose what fits

 

A recent paper tries to develop a unified theory of trend-following by classifying trend-following into three groups; see “The science and practice of trend-following systems”. 

The authors break trend-following into three types: European, American, and Time Series Momentum. 

European trend-following is based on continuous weights using an EWMA filter. In this system, position sizes are proportional to the signal strength, with the number of contracts changing day to day.

American trend-following uses channel or breakout systems with binary position sizes, so exposure is fully allocated when a signal is on. 

Time series momentum is based on the momentum of returns adjusted for volatility. 

There are parameter specifications that will deliver similar risk-adjusted returns close to the SG trend index. 

All of these trend-following systems are strongly correlated, yet there are differences in position-taking and signaling. The success of trend-following is based on the serial dependence of the underlying price series. Differences in performance will be related to differences in short- and long-term variance, and signals are related to an autocorrelation and drift term. Profits are related to an autocorrelation term even if drift is zero. 

A benign inflation number - now what?

Inflation numbers were within expectations, yet this is not something to celebrate. Core inflation is still above the 2% target, and headline inflation is still above 3%. Has the Fed been successful with its policy? The answer is no. However, the current inflation numbers suggest that no action will be taken at the September FOMC meeting. Policy changes are unlikely before an election, and that will take us to the end of the year to see any policy rate change. 

The important monetary policy information will come from the Jackson Hole conference and any headway from the five task forces reviewing policy. Chairman Warsh, if current behavior is a guide, is unlikely to tip his hand about policy at the Kansas City Fed confab, so the market will have to make decisions for itself on the direction of rates.