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Paratrade Systems Weekly Research News

2 Nov

What can drive risk premia higher?

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One of the big concerns for macro portfolio managers is that the risk premia decline we have seen over the last 20 years may violently reverse. If that were to happen then perhaps many of the relationships, we define as normal might explode:

  1. Interest rates may finally rise to much higher levels to reflect the quantity of the money supply overhang.
  2. Corporate bond spreads will widen enormously as excess supply and weakness in nominal GDP growth will weaken all corporate credits.
  3. Mortgage bond spreads similarly widen as weak housing demand and high consumer credit make this sector very unattractive.
  4. Weak credit conditions in the Euro PIIGS force those yields considerably higher once again forcing us to ask how the EU will handle debt rollovers in Greece and Portugal – at least to start.
  5. Stock market PE multiples fall as anemic earnings growth render stocks less attractive as do competition from higher bond yields.

We need to study the nature of the Risk Parity position to understand why it has consistently rallied over the last twenty years. If we can find critical inter-market associations, then we can watch for adverse movement in those relationships to prepare ourselves for rising risk premia.

How does RP respond to changes in stock and bond returns?

We’ll work with weekly data so we can see slightly longer term impacts of different conditions. What we know is that interest rate declines cause a rise in the S&P and the converse so we’ll look at both. We need to see if (say) an S&P decline engenders a great enough bond rally to offset any subsequent mean reverting five-day pullback in the S&P.

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Overall this did work but captured only half the overall gain in the index itself and barely made any more money than the converse. The problem stems from the fact that bond rallies do not necessarily follow a stock market decline and when they occur they don’t necessarily offset the continuing weakness of the S&P 500 (or the converse).

Now we shall look to see what happens after bonds rally (or fall):

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It seems that when bonds rally stocks respond the following week and when they do, they do not pull bonds down enough to offset the scale of the stock move. The net benefit is clearly positive for RP. We see that it captures 2/3rds of the entire gain while missing all the poor performance of ’04-’09. The only time it performed worse than the market was in the second quarter of 2013. This is a very limited rule and certainly doesn’t constitute a system but the conclusion is clear:

A steady rising value of Risk Parity (or decline in risk premia) is utterly connected to lower interest rates. I guess it’s no big shock but the simplicity of the association did surprise us.

We also studied the effect of rising oil prices, utility stock prices, foreign bond behavior and the US dollar but none offered any value or information. We do have a fuel gauge for Risk Parity. It is explained HERE.

 

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