View from the floor – Macro signals suggest continued risk-on | Mann Institute

Macro signals suggesting continued risk-on

History never repeats itself, but it often rhymes. Understanding the drivers of returns in previous market regimes helps investors project history into the future and maximize the probability of success in capturing alpha. In July, we provided a macroscopic look at why markets remained bullish in the second quarter despite many investors’ expectations that stagflation and rapidly rising interest rates would take the wind out of the global economy’s sails. We have detailed how algorithms can exploit and explain this historical awareness.¹

After almost a full quarter of interest rate hikes in the US, Eurozone, and UK (even if the Federal Reserve and Bank of England continued their hawkish lull last week), the US bond market has The economy continues to show signs of recession, along with yields. The curve remains inverted for more than 200 consecutive business days² So what does the market think now?

By examining the similarity measures, our model still shows that current markets are behaving least similarly to the meltdown era of the global financial crisis in late 2008, early 2013, late 2016, and We see it as most similar to a calmer period, such as late 2019.

Additionally, recently developed machine learning algorithms that help guide our top-down positioning indicate a primarily risk-on regime, with momentum and beta themes currently overwhelmingly driving market returns. , and typical defensive themes such as earnings yield are not favorable. However, we also suggest adding some diversification through themes such as investment quality and size (Figure 1).

Figure 1. Risk-on style dominates today’s market

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Source: Man Numeric, using MSCI Barra coefficients.

Supervised Macro Scope (SMS) is another supervised machine learning algorithm we use to add a more dynamic and opinion-based view of the current macroeconomic environment to further guide weighting within positioning. To do.

From the chart below, we can see that SMS supports momentum and beta as its dominant themes, but also chooses to express this risk-on sentiment with leverage. In particular, the model’s strongest observation is investment quality (Figure 2).

Figure 2. Further risk-on view from supervised macro scope

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Source: Man Numeric.

Despite the continued rise in interest rates, the market appears to remain firmly in a risk-on mood, and while a defensive style is out of favor, some quality measures could boost performance.

Central bank closely monitors government bond-based transactions

Last week, the Bank for International Settlements³ It became the fourth institution to sound the alarm over hedge funds’ accumulation of leveraged short positions in U.S. Treasury futures.

Since May, the U.S. Securities and Exchange Commission (SEC), Federal Reserve System (FRB), Bank of England^Four It warns that such U.S. Treasury-based transactions could seriously destabilize financial markets.

BIS estimates that leveraged funds have accumulated a net short position in Treasury futures of approximately $500. $At $600 billion, over 40% of the net shorts are concentrated in two-year contracts. Figure 3 shows the total net holdings of leveraged funds relative to asset managers’ long-term holdings.

Figure 3. Accumulation of leveraged positions in U.S. Treasury futures

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Source: Bloomberg, asset manager holdings are 2-year + 5-year + 10-year net holdings, leveraged fund holdings are 2-year + 5-year + 10-year net holdings.

How does Treasury bond-based trading work?

Simply put, Treasuries-based trading is arbitrage that takes advantage of the price difference between Treasury futures and Treasuries. If futures trade richly relative to cash, hedge funds will try to arbitrage this by selling futures against long-dated physical bonds. This criterion is so small that hedge funds have to apply large leverage to expand their dividends. The mechanism works as follows.

Hedge fund:

1. buy government bonds
2. We transfer these Treasury bonds to the repo desk to raise funds and store them.
3. Short-term government bond futures

When the futures mature, the hedge fund takes delivery of the government bond and closes the short futures position. Complete the financing from your payments and keep the difference as profit.

What are your concerns?

The problem arises when volatility in the U.S. Treasury market suddenly spikes, forcing hedge funds to liquidate and deleverage all at once. This was seen in his early 2020 and earlier this year after the Silicon Valley Bank collapse (see Figure 5 later in this article). The illiquidity and turmoil in the Treasury market was large enough for the Fed to intervene to provide liquidity and restore order. Leveraged funds are currently in a similar net short position, according to BIS.

An even bigger concern is the amount of government bond issuance that will flow into the market. According to Goldman Sachs estimates, $Next year, 2.7 trillion yen is expected to be issued in 10-year terms. $This year, the 10-year equivalent is $2.3 trillion (see last column below).

Figure 4. Net issuance of U.S. government debt is likely to increase in the second half of this year.

Source: U.S. Federal Reserve System, Goldman Sachs estimates.

It’s also worth remembering that the U.S. Treasury was banned from issuing one this year due to political tensions over the debt ceiling. Most of the issuance is expected to take place in the second half of the year after Congress raised the debt ceiling in early June.

The risk is that if the current trend of asset managers going long and hedge funds shorting Treasury futures (through basis trading) continues as Treasury issuance increases, unforeseen events could lead to a decline in 2020. This means that there is a possibility that the scenario in 2020 and March 2023 will be repeated.

Figure 5. The MOVE index, which captures volatility in the U.S. Treasury market, shows how volatility spiked in early 2020 and March 2023.

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Source: Bloomberg.

In the current environment, two scenarios could force hedge funds to rapidly unwind basis trades. One is if the market moves against the hedge. For example, if a repo position is too tight to roll. Another possibility would be if bond market volatility forces banks to increase margin on short positions in government bonds.

Eric Wu, Principal, Quantitative Alpha Integration and Strategy, Valerie Xiang, Associate Portfolio Manager, Scott Skirlo, Associate Quantitative Researcher, Numeric Investment Management, and Emerging Markets Debt Strategy GLG EM Fixed Income Portfolio – Contributed by manager Ehsan Bashi.

1. View from the Floor – July 4, 2023 | Mann Institute | Men’s Group
2. www.bloomberg.com/news/articles/2023-09-14/the-bond-market-has-never-soundedrecession-alarms-for-this-long
3. www.bis.org/publ/qtrpdf/r_qt2309a.htm
4. www.bloomberg.com/news/articles/2023-05-26/debt-ceiling-battle-brings-popular-hedge-fund-trade-fresh-scrutiny
www.federalreserve.gov/econres/notes/feds-notes/recent-developments-in-hedge-funds-treasury-futures-and-repo-positions-20230830.html#fig4
www.bankofengland.co.uk/financial-stability-report/2023/july-2023