Trend-following and rising rates – A world of difference

There is the old view that trend-followers do not make high returns trading rising rate environments. Generally, that view has been true for several reasons. 

One, the trend in rates has been down since the early 1980's, consistent with the decline inflation and real rates. Two, rising rate periods have not lasted long and have generally been linked with higher volatility. The opportunity for short Treasury trades have been fewer. Three, central banks have shown a bias toward capping rate increases, the Greenspan put. Four, central banks have been involved with QE since 2008 which pushed rates lower. Money was made with shorting bond futures, but it was not easy profits and the rising rate trends were not as extended as the rate declines even with a zero bound. Four, during the period of rising rate in the 1970's, bond futures were not actively used. We don't have good information on how the trend-followers would have done. There can be assessments based on rate data, but not futures. 

The world has changed over the last year with the Fed raising rates with a consistent change in policy. Trend-following is conditional on the global macro environment. We are now in a Fed hawkish environment with repeated increases in rates. The result has been an extended trend higher in rates and trend-followers making money from the short side. This Fed change does not mean one-sided trading but there is a tilt to rate increases with short-term reversal; the opposite of pre-pandemic decades where the tilt was to lower rates with intermittent rate increases.   

Sahm Rule recession indicator - Not at critical level but trend is higher

The Sahm Rule is a good recession indicator based on the simple calculation of the three-month moving average of the national unemployment rate U3 by .5 percent or more over the low of the last 12 months. Clearly, if the unemployment rate is falling, no recession. If the unemployment rate is rising relative a past low, it can be a signal for a recession. The number can get fairly high with the peak reaching at the end of the recession. The graph does not do justice to the key threshold of .5; nevertheless, the Sahm Rule will give a strong indication of a recession. This may not be a true early warning, but it provides a clear lowdown signal. The FRED database provides a real-time and adjusted Sahm Rule where the adjusted value accounts for revisions.

If we look at the last year, the indicator has moved from negative to positive and is showing a strong trend, yet it is not near the key .5 level. The trend directional change is correlated well with the market top. 

Economic trade projects diplomatic power

Economic power projects diplomatic power. Trading partners will listen to each other. This is both a reality and necessity; however, the influence may be one-sided.

Economic powers will project their values, political system, and culture. It may not happen immediately; however, cultural and political hegemony will march with economic trade. 

The switch in trading hierarchies from the US to China is astounding and consistent with the strong growth in China and its need for resources. The China effect is driven by extraction from emerging markets and the sale of goods to developed markets. This process is still relatively young so the credit, banking, and currency implications have still not matched the trade relationships. 

Given the current struggles between the US and China, the exertion of power on trading partners will grow. China may not look for active but silent partners who will not interfere with their politics. The US will look for friends to shore its trade, but it is less dominant around the world. All this will play-out in debt and equity markets as EM firms may have to side with their economic interests. We have already seen some of these trade politics play through the oil markets. 

Autocorrelation of stocks and bonds - why is it hard to trend-follow with stocks

It is very simple rule. It is hard to make money using a trend-following model if there is no positive autocorrelation in returns. It is even more difficult if the asset shows negative autocorrelation. A recent paper looks at 60 years of data to measure the autocorrelation of individual stocks, equity portfolios, and bonds. See "Autocorrelation of stock and bond returns, 1960–2019".

Beyond the implications for trend-following, this work shows that the autocorrelation for stocks and bonds changes through time. For individual stocks, the autocorrelations are always negative, but there is significant ebb and flows in the size of this time series effect. For equity portfolios, the autocorrelations have moved from positive to negative. For bonds, the author finds that autocorrelations have moved from strongly positive to negative like stock portfolios. The paper presents autocorrelation data on portfolios and stocks conditional on factors such as volatility, turnover, and size. 

It finds that smaller cap stocks show more negative autocorrelation across all time periods while large caps are closer to random. Lower turnover stocks show more negative autocorrelation. High volatility stocks show more negative autocorrelation.

Small stock portfolios have more positive autocorrelation. Low turnover and low volatility portfolios have more negative autocorrelation.

Any investor has to fight the natural time series behavior of stocks which is to reverse the direction and show negative autocorrelation. Investors should use this tendency to their advantage.