Macro-Investment Risks and Style Selection Michael Howell LQG Spring Seminar 18th May 2017 At The Royal Geographical Society 1 Kensington Gore, SW7 2AR
D-Star (Position of Curvature Peak in Years, 6-month CMA, Advanced 15 months and Inverted) and B-BBB Corporate Credit Spread Monthly 1987-2016 4 The position of the curvature peak (D-star) advanced by 15 months and inverted predicts future movements in the US corporate high yield spread between single B and BBB bonds. The negative correlation between the two series is minus 0.563 and D- star is strongly one-way Granger causal. 14 4.5 12 5 10 5.5 8 Years 6 6 6.5 4 7 7.5 2 8 0 01/01/1987 01/03/1988 01/05/1989 01/07/1990 01/09/1991 01/11/1992 01/01/1994 01/03/1995 01/05/1996 01/07/1997 01/09/1998 01/11/1999 01/01/2001 01/03/2002 01/05/2003 01/07/2004 01/09/2005 01/11/2006 01/01/2008 01/03/2009 01/05/2010 01/07/2011 01/09/2012 01/11/2013 01/01/2015 01/03/2016 Per Cent B-Baa D-Star(6m MA, inverted) 2
Yield Curve Level, Slope, Curvature and Position Schematic breakdown of term structure into four parameters: level, slope curvature and position Yield (y m ) Curvature (e.g. y 10 (y 20 + y 1 )/2) Level (e.g. y 1 ) Slope (e.g. y 20 y 1 ) Position (i.e. D-star (D * )) Duration/ Maturity (m) 3
Calculation of D-star (m 0, y m0 ) (p,q) At each point in time (t), there exist distance measures for each maturity m = 0,,n. The distance-weighted average of these maturities describes the position of the hump (D t* ):, 0 0,, 0 where w m,t = d m,t / d m,t is the weighting factor for each tenor, m 4
D-star (6-month CMA) and a Fourth Kalman Factor Filtered from Affine Yield Curve Monthly 1982-2016 I take a 6-month centred moving average (CMA) of the generic D-star estimates and plot this against a fourth Kalman factor (KF1) filtered from the US term structure modelled from an affine yield curve model. The three other Kalman factors correlate closely to the traditional level, slope and curvature measures. The correlation between D- star and the Kalman factor is 0.777 (0.503, 1946-2016). Source: Author s calculations 5
Granger Causality Tests Summary Results US ISM is the Institute of Supply Management national index of US manufacturing activity; Philadelphia Fed Index is a regional index of manufacturing activity; U of M Consumer Sentiment is the 12 month change in the University of Michigan survey; the Quality, High Yield and Junk Yield Spreads are credit spreads; the MOVE index is the Merrill Lynch measure of US bond market volatility; VIX is the CBOE measure of US equity volatility; Risk Aversion is a variance-based measure derived from the VIX; ECB Global Risk Aversion is a composite index derived from other vendors summarising global risk aversion; CBC Risk Appetite refers to the CrossBorder Capital index based on actual asset holdings; Kansas Fed FSI is the financial stress index published by the Kansas Federal Reserve, and PC1 FCI is the first principal component of all published financial stress indexes by regional Federal Reserve districts. A denotes a positive; x denotes a negative and /o signifies at least as good as. GC denotes Granger causality. Indicator Significant GC 12-18 months One-way GC Outperforms Other YC Parameters Robustness Check Over Longer Sample PC1 FSI Kansas Fed FSI Quality Credit Spread BBB-AAA High Yield Spread B-BBB Junk Credit Spread CCC-B MOVE Index VIX Index /o US ISM Philadelphia Fed Index U of M Consumer Sentiment(12m ch) ECB Global Risk Aversion x /o Risk Aversion /o CBC Risk Appetite x /o /o 6
Testing Prediction With Bayesian Information Criteria (BIC), where Y t+k is the predicted factor k periods ahead, e.g. the ISM index of US manufacturing business activity; PC i,t represent the first three principal components of the US Treasury yield curve; D * t is D- star av in period t, and ε t is a random error term. α, β i and γ are parameters to be estimated. The same structure is adopted for all predicted variables. The estimation uses the available monthly data over the period. The time horizon k takes the values 3, 6, 9, 12, 15, 18 and 24 months. 7
First Principal Component of Major Financial Stress Indexes (FSIs) Monthly 1994-2016 BIC refers to the Bayesian Information Criteria reported for different time horizons from 3 months to 24 months. B/M+D-star denotes the regression, but including D-star as a second regressor. D-star refers to the regression without the benchmark variable. The same applies to the R 2 statistic. 8
US ISM Index 1954-2016 and 2000-2016 US ISM Manufacturing Survey is a monthly barometer of US economic activity. 3x YC PCs denote the first three principal components of the Treasury yield curve. BIC refers to the Bayesian Information Criteria reported for different time horizons from 3 months to 24 months. B/M+D-star denotes the regression, but including D-star as a second regressor. D-star refers to the regression without the benchmark variable. The same applies to the R 2 statistic. Two samples are reported: 1954-2016 (left) and 2000-2016 (right). 9
BIC Tests on Risk Appetite Using Three Benchmarks, various time periods (LHS CFFCI, Middle 3xYC PCs, RHS Real Term Premia) Row 1: ECB Risk Appetite; Row 2: Risk Aversion from VIX; Row 3 CBC World Investors Risk Appetite The chart reports the BIC for regressions that include and exclude, where stated, the D-star variable. The left-hand column of three charts uses a benchmark based on the Chicago Fed National Financial Conditions Index to predict three measures of risk appetite 3-to-24 months ahead: (a) ECB Global Risk Appetite (1996-2016); (b) Risk aversion from VIX variance premium (1984-2016) and (c) CBC World Investors Risk Appetite (1978-2016). The middle and final columns do the same, but with different benchmarks based, respectively, on the first three principal components of the Treasury yield curve and the real US Treasury average term premia. The introduction of D- star adds information, notably to the first two rows, which, respectively, show the ECB s global appetite measure and a risk aversion measure based on the CBoE VIX index. Source: Author s calculations and Federal Reserve 10
Event Study: Y2K Bubble Finance Crisis D-star (Advanced) and Selected Macro-Finance Variables Monthly 1999-2003 D-star measures the lateral position of the hump in the US Treasury yield curve along the maturity axis. It has been advanced by the number of months indicated to align with each of the other reference series in the chart panels. B-Baa refers to the corporate credit spread; real TP10 is the nominal term premia of the 10-year US Treasury, with an inflation trend removed by orthogonal regression; FSI PC1 is the first principal component of published FSIs and USISM is the US purchasing managers index of business activity. In the 1999/ 2000 Y2K period, D-star appears to lead the credit and financial markets by around 9 months and the real economy by some 12-15 months. 11
Event Study: Global Finance Crisis D-star (Advanced) and Selected Macro-Finance Variables Monthly 2006-2010 D-star measures the lateral position of the hump in the US Treasury yield curve along the maturity axis. It has been advanced by the number of months indicated to align with each of the other reference series in the chart panels. B-Baa refers to the corporate credit spread; real TP10 is the nominal term premia of the 10-year US Treasury, with an inflation trend removed by orthogonal regression; FSI PC1 is the first principal component of published FSIs and USISM is the US purchasing managers index of business activity. In the 2007/08 GFC period, D-star appears to lead the credit and financial markets and the real economy by 12-15 months, but bond markets by significantly less. 12
Performance of Portfolios Based on HedgeFund (HFRIFWC) & Barclay CTA (BARCCTA) Monthly 1990-2017 13
Performance of Portfolios Based on S&P500 (SPX Futures): Spot, Simple IOMMA Trend-Follower and D-Star Monthly 1990-2017 14
Summary Results HedgeFund (HFRI) & Barclay CTA (BARCCTA) Dstar HFRIFWC/BARCCTA Trend Follower HFRIFWC/BARCCTA Long HFRIFWC/BARCCTA Annualised Average Return 8.88% 4.90% 6.15% Annualised Volatility 6.74% 4.23% 4.87% Sharpe Ratio 1.32 1.16 1.26 S&P 500 (SPX Futures) DStar SP 500 Trend Follower SP500 Long SP500 Annualised Average Return 9.36% 7.07% 7.39% Annualised Volatility 10.91% 10.24% 14.46% Sharpe Ratio 0.86 0.69 0.51 15