A SURVEY OF LIQUIDITY, RISK APPETITE AND GROWTH INDICATORS: WORST FEARS OUT OF THE WAY

1. Fed Funds-GC Repo Basis Narrowed



2. 3-Month Libor-OIS Basis Contracted



The FF-GC basis had widened significantly last year due to stress in funding markets and risk aversion, leading to a severe shortage of treasury collateral. This was one of the factors pushing 2-year swap spreads wider. This basis has normalized due to the Fed's pro-active policy measures and a significant increase in treasury supply. Another peg in the same equation was the LIBOR-OIS basis. Interbank cash markets were dis-functional due to counter-party risk concerns among banks. This was preventing the Fed's policy stimulus from flowing through into cash markets. Narrowing of both these spreads is good news for the transmission mechanism of monetary policy and ultimately, growth.

3. Baltic Dry Index Off the Lows



Is this a reflection of the Chinese stocking activity or a genuine pick up in growth? Hard to say, but the trend over the last couple of months does indicate that the world economy has most likely bottomed.

4. Oil Outperforming Oil Stocks



This was certainly the case early last year when oil rose to stratospheric levels. Equity investors questioned the sustainability of the move in the underlying commodity and were right. I would agree with stocks this time as well because a significant increase in oil price at this stage of the cycle will likely nip the incipient recovery in the bud.

5. Gold Stocks Outpacing Gold



Gold is a great bet going forward. What is the probability that global central banks will get it just right? Pretty low, in my view. Most likely, monetary authorities will be late in withdrawing the extraordinary stimulus, making inflation a real risk at some stage in the future.

6. VIX is Significantly Down from the Highs



When equities collapsed in early 2009, the VIX did not climb back to the post-Lehman levels. This indicates that investors are now more sanguine about the worst fears expressed during the last quarter of 2008.

Overall, I think that we now can invest as if we are in a standard recession. I had always thought that proactive policy measures would minimize the probability of the Great Depression tail event. That is what the markets are saying now and I concur wholeheartedly.

BUY AND HOLD?

The S&P 500 flirted with a "supposedly" important technical level – the 20-day moving average – on Friday. I decided to back-test the historical (May 19, 1982 to February 20, 2009) performance of two simple rules - trend-following and contrarian - based on this technical parameter.

Rule #1: Trend-following
Buy on the close, if S&P 500 > 20-day moving average
Liquidate on the close, if S&P 500 < 20-day moving average

Rule #2: Contrarian

Buy on the close, if S&P 500 < 20-day moving average
Liquidate on the close, if S&P 500 > 20-day moving average

To say the least, the results for the simple trend-following strategy are quite dismal. The order of return dominance (See Exhibit 1) over the entire back-testing period is the following:

1. Buy & hold: $1 invested in the S&P on May 19, 1982 would have grown to $6.71 by February 20, 2009 (7.37% average annual return).
2. Contrarian: $1 invested in the S&P on May 19, 1982 would have grown to $3.35 by February 20, 2009 (3.35% average annual return).
3. Trend-following: $1 invested in the S&P on May 19, 1982 would have grown to $2.00 by February 20, 2009 (2.63% average annual return).

However, there are important variations over different time periods. The trend-following strategy broadly outperformed until about 1998. Since then the contrarian rule held sway. Buy & hold proved the best across time intervals.

Exhibit 1: Value of $1 Invested in Different Strategies: May 19, 1982 to February 20, 2009



Exhibit 2: Relative Performance (Trend Following/Contrarian): May 19, 1982 to February 20, 2009



Source: Bloomberg

SYSTEMATICALLY TRADING GOVERNMENT BONDS USING SIGNALS FROM THE OVERNIGHT INDEXED SWAP MARKET

STATISTICALLY SIGNIFICANT AVERAGE PROFIT OF 1BP PER TRADE; BID-OFFER SPREADS COULD BE AN ISSUE*

A theoretical case is often made for the derivatives market responding faster than the cash segment to economic data and policy announcements. If this assertion is true, then signals from the synthetic space can be used to trade cash instruments.

In the Indian context, I tested this hypothesis using 5-year/10-year government security yields and the 5-year overnight indexed swap rates.

The results are encouraging. OIS rates lead the moves in the government securities market. There is evidence of a positive follow through (positive moves followed by positive, negative followed by negative). A simple trading rule designed to trade government securities generates statistically significant profits.

The back-testing exercise indicates average profits of about 1 basis point (t-statistic >5) per round trip. I have not accounted for bid-offer spreads. Yet, market makers can certainly exploit this empirical regularity (because they do not have to cross bid-offers).

Rule # 1: 5-year OIS and 5-year Gsec

Data: Daily closing yields from February 2, 2003 to April 29, 2009

Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash

Correlation (OIS (-1), Gsec (0)) = 0.22
Correlation (OIS (0), Gsec (0)) =0.50
Correlation (OIS (0), Gsec (-1)) = 0.01

Trading Rule

If Delta (5-year OIS Rate) > 0, then short 5-year government bonds
If Delta (5-year OIS Rate) <0,then buy 5-year government bonds
Delta: Daily close to close
Trade: Daily close to close

Performance Statistics*

Mean (bp): 1.1
Standard deviation (bp): 6.7
t-statistic: 6.6
No. of Positions: 1498
No. of loss-making positions: 624 (42%)
Maximum Gain (bp): 63.6
Maximum Loss (bp): 45.4

Rule # 2: 5-year OIS and 10-year Gsec

Data: Daily closing yields from July 23, 2001 to April 29, 2009

Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash

Correlation (OIS (-1), Gsec (0)) = 0.14
Correlation (OIS (0), Gsec (0)) =0.48
Correlation (OIS (0), Gsec (-1)) = 0.03

Trading Rule

If Delta (5-year OIS Rate) > 0, then short 10-year government bonds
If Delta (5-year OIS Rate) <0, then buy 10-year government bonds
Delta: Daily close to close
Trade: Daily close to close


Performance Statistics*

Mean (bp): 0.88
Standard deviation (bp): 6.9
t-statistic: 5.4
No. of Positions: 1801
No. of loss-making positions: 751 (42%)
Maximum Gain (bp): 76.5
Maximum Loss (bp): 79.9

* Performance statistics not adjusted for the duration of the security traded.
Source: Bloomberg; IMF Working Paper: Derivatives Effect on Monetary Policy Transmission