Since the beginning of 2022, although inflation stays at a high point, but with the Federal Reserve actively expressing its determination to curb inflation and the federal fund rate of interest rate hikes, inflation is no longer the same as the rapid rise from 2020 to 2021. Instead, it is in a plateau period and fluctuates. Therefore, it is time to re-examine inflation-related strategies and find an appropriate time to exit.
We started by looking for leading inflation indicators and browsing a series of papers. The topics included leading indicators of inflation, inflation risk premium, stock-bond correlation, etc. However, digging deeper into the data in the papers, we found that most of them used relatively lower frequency datasets: monthly and quarterly data. It is eligible for macroeconomic analysis but not instant enough for portfolio management goals.
In 2020, A. Cieslak and H. Pang published the paper Common Shocks in Stocks and Bonds, whose main contribution is to use real-time market information and prior knowledge of the market reaction to convert them into macroeconomic economic factors. The method provides more instant macroeconomic factors, including growth factor, monetary factor, hedging premium, and common premium.
However, how to apply the converted macroeconomic factors into portfolio management? Here we only use the monetary/inflation factor, and borrow the ideas from the paper When Stock-Bond Diversification Fails-Managing inflation risk in investor portfolios to judge the current inflation situation using the normalized z-value. When z-value exceeds 1, it is considered an upside trend period, the z-value between -1 and 1 is a stable region, and the z-value less than -1 is a downside trend period. Combining the z-value with our inflation indicator established by the breakeven rate. We found that adding the judgment of the z-value can significantly increase the return of inflation-protected treasuries and pure inflation strategies in the high inflation area. The results are shown in the table below.
|Annualized Return||Data Length (days)||Inflation Protected Bond ETF (TIP)||Pure Inflation Strategy |
( TIP – IEF)
|High Inflation and z-value >-1 (stable region or upside trend)||301||7.5%||15.03%|
In a high-inflation environment, when the z-value is in a stable region or upside trend period, TIP and pure inflation strategy have more than 100% more annualized returns than those in the high-inflation environment only. It proves that the z-value provides excellent potential for inflation-related strategies improvement. Next, we will focus on further use of the monetary/inflation factor and analyze more details.
AVP of Quantitative Finance, Gamma Paradigm Research