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Inflation not down under!Australia's CPI data, released yesterday, showcased figures hotter than anticipated. While this may not be 'reaction-worthy' news on its own, the scenario in Australia is worth delving into for several reasons. Inflation Trends Initially, let's consider inflation trends. In most western economies, although inflation remains above central bank targets, the trends are on a downward trajectory. However, when juxtaposed against those for the European Union (EU) and the United States (US), Australia's (AU) inflation rates on a month-over-month (MOM) and year-over-year (YOY) basis still stick out from the norm. Moreover, yesterday’s CPI prints surpassed consensus on both the YOY & MOM basis, indicating a notable deviation from expectations. In fact, Australia's YOY CPI is now on its longest streak above inflation expectations, and crucially, inflation expectations have ceased revising downwards. Given the higher inflation levels compared to its peers, consensus estimates, and expectations, inflation remains a significant concern for Australia. Interest Rates In the realm of interest rates, Australia has been a long-standing “pauser,” having maintained its policy rate unchanged since its June meeting. This prolonged pause now further opens the leeway to raise rates, especially given the “watch and see” approach adopted towards burgeoning inflation. Additionally, its interest rates remain low compared to the US, EU, Canada, and even New Zealand. As a result, on the real rates basis, Australia trails far behind, with its policy rate still 1.3% behind its inflation rate, significantly less restrictive compared to other economies that have already moved into positive real rates territory. We posit that the RBA is behind the curve and has room to react, given the considerably long period of pause and still negative real rates. The market seems to echo this sentiment too, as the odds for a hike in the next meeting surged post the CPI news, moving from 21% to 55%! Against multiple currencies, the AUD appears to be threading above the long-term support level, a threshold that has essentially defined AUD low. This strong support is expected to hold, given its tested and respected level across multiple currency crosses since 2020. Policy turning points between the two currencies, as indicated by the turn in the interest rate differential, have generally marked the trend change for the currency, notably for the AUDEUR pair. Given the persisting high inflation in Australia compared to various economies and metrics, should market expectations trend in the right direction, it's plausible the Reserve Bank of Australia (RBA) may react with a rate hike. This action could tilt the rate differential and interest for the AUD, bolstering the currency. To capitalize on this bullish view on the AUD, we can consider a long position on the AUDEUR. We can set up this trade via a long position on the CME Australian Dollar Futures and a short position on the CME Euro FX futures to create a synthetic long AUD/EUR position at the current price level of 0.5951, stop at 0.5865 and take profit at 0.615. Given that one CME Euro FX futures is for 125,000 Euros and one CME Australian Dollar Futures is for 100,000 Australian Dollars, this suggest that we should use two Australian Dollar Futures to one Euro FX Futures to match the contract size, given that 125,000 Euros is roughly equivalent to 210,000 Australian Dollars at the prevailing exchange rate. Each 0.00005 increment in the Australian Dollar Futures is equal to 5 USD and each 0.00005 increment in the Euro FX Futures is equal to 6.25 USD. The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com Disclaimer: The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description. Reference: www.cmegroup.com www.cmegroup.com melbourneinstitute.unimelb.edu.au www.rba.gov.au www.asx.com.au www.cmegroup.com
ECONOMICS:AUINTRLong
by inspirante
2
Inflation SupercycleOn the afternoon of October 3rd, 2023 something unprecedented happened in the U.S. Treasury market. For the first time ever, bear steepening caused the 20-year U.S. Treasury yield and the 2-year U.S. Treasury yield to uninvert. Bear steepening refers to a scenario in which long-duration bond yields rise faster than short-duration bond yields, as bond yields rise across the term structure. In all past instances, inverted yield curves have normalized due to bull steepening . The probability that bear steepening would cause an inverted yield curve to normalize is so low that, until now, most term structure models excluded the possibility of it ever happening. In this post, I'll explain why this anomalous event is a major stagflation warning. The chart above shows that the 10-year Treasury yield has been rising much faster than the 3-month Treasury yield throughout 2023, narrowing the once-deep yield curve inversion. Since a yield curve inversion indicates that a recession is coming, and bear steepening indicates that the market is pricing in higher inflation for the short term, and even more so, for the long term, then bear steepening during a yield curve inversion indicates that high inflation may persist even during the recessionary phase. High inflation during the recessionary period is what defines stagflation . Since very strong bear steepening is normalizing a deeply inverted yield curve, the combination of these events is a warning that severe stagflation is likely coming. High inflation has caused Treasury yields to surge at an astronomical rate of change. Bond prices, which move in the opposite direction as yields, have sharply declined causing destabilizing losses. The effects of these massive bond losses are not even close to being fully realized by the broad economy. The image above shows a bond ETF heatmap with year-to-date returns. Large losses have been mounting across numerous bond ETFs. Long-duration Treasury ETF NASDAQ:TLT has declined by more than 18% this year. Click here to interact with the bond ETF heatmap Despite the extreme pace of monetary tightening, many central banks are still struggling to contain inflation. Inflationary fiscal spending and ballooning debt-to-GDP levels are confounding central bank monetary policy efforts. In Argentina, for example, inflation continues to spiral higher despite the central bank raising interest rates to 133%. The chart above shows that the central bank of Argentina has hiked interest rates to 133%. Despite this extreme interest rate, the country's inflation rate continues to spiral higher. In an inflationary spiral, there is no upper limit to how high interest rates can go. As the Federal Reserve tightens the supply of the U.S. dollar -- the predominant global reserve currency -- all other countries (with less demanded fiat currency) generally must tighten their monetary supply by a greater degree in order to contain inflation. If a country fails to maintain tighter monetary conditions than the Federal Reserve, then the supply of that country's (lesser demanded) fiat currency will grow against the supply of the (greater demanded, and scarcer) U.S. dollar, causing devaluation of the former against the latter. In effect, by controlling the global reserve currency, the Federal Reserve is able to export inflation to other countries. This phenomenon is explained by the Dollar Milkshake Theory . The forex chart above shows FX:USDJPY pushing up against 150 yen to the dollar. The longer the Bank of Japan continues to maintain significantly looser monetary conditions than the Fed, the longer the yen will continue to devalue against the U.S. dollar. The meteoric rise in bond yields is particularly concerning because it has broken the long-term downtrend, signaling the start of a new supercycle. After hitting the zero lower bound in 2020, yields have rebounded and pierced through long-term resistance levels. The chart above shows that the 10-year U.S. Treasury yield broke above long-term resistance, ending the period of declining interest rates that characterized the monetary easing supercycle. We've entered into a new supercycle, one in which lower interest rates over time are a thing of the past. The new supercycle will be characterized by persistently high inflation. It will start off insidiously, with brief periods of disinflation, but over the long term it will accelerate higher and higher, ultimately causing today's fiat currencies to meet the same fate that every fiat currency in history has met: hyperinflation. * * * Important Disclaimer Nothing in this post should be considered financial advice. Trading and investing always involve risks and one should carefully review all such risks before making a trade or investment decision. Do not buy or sell any security based on anything in this post. Please consult with a financial advisor before making any financial decisions. This post is for educational purposes only.
Editors' picks
FRED:M2SL
by SpyMasterTrades
46
US stocks to bonds in relation to FED interest rate & inflationPotential equity upside: uncertain. Potential equity downside: uncertain. FED is currently paused at 5.5% interest rates, and even if they did increase rates again like they did in 2000 after pausing at 5.5% from 1995-1998, a pivot to start decreasing rates is due in the coming years- continuing the long term stock/bond market cycle. 30 year bond yields at levels not seen since 2007…but still has 25% upside to reach levels of 1999. Going from current 5.08% to 6.43% where the 30 year yields peaked going into the tech bubble inflation era. That was FED interest rates at 5.5% from 1995-2000… FED pivot: certain. FED pivot time: uncertain Will inflation continue to run hot as tech gains continue? Or will crazy bond yields break the banks and they need a bailout amidst a prospective world war really putting FED in a pickle… How I’m going to position solely for a FED pivot: start buying bonds now as we are in the beginning of rates being paused (yellow arrow on chart) and risk off equity. I like cost averaging into TMF even if it ends up being for the next 5 years- in comparison to 1995-2000 inflation levels. That is why dca is very important and to not use funds needed for daily living. If that were the case, selling covered calls generates easy income and can add that profit to equity position to dca further. That is until FED interest rates start being lowered. At that point, hold the current average cost. That is shown on the chart as a red arrow down. Do not take profit until what is shown on the chart as a blue arrow, or when FED interest rates are paused while decreasing. The potential to miss equity upside is there up until the FED pivot. That, to me, is just what it is. Chasing equity high up until FED pivot. And I am not comfortable doing that with prospective world wars beginning involving USA. However, the potential for bond face value appreciating for years to come while inflation goes back down to 2% goal is far greater. The time that comes is just uncertain. But certainly, it will come. Dividend yields remain high until rates pivot down, so with this strategy, there’s fixed income along the way. And is intended from dca to never realize any loss. When US inflation rate is back below 2% target goal, whenever that is, start to add on equities. When FED interest rates start increasing again, sell all 20 year bonds and full risk on equities.
ECONOMICS:USINTR
by raylanboogie
Again macro conditions don't foretell a crash soonIn May and August I made posts saying "Macro conditions don't foretell a market crash soon." Time has passed and it's all pretty much the same. BUT!! Current world events might change everything. And see my other posts re likely imminent drops in the market. This post is just about macro. Once again, some points here looking back to 2001. (2020 was an irregular event). Sorry for all the colors here, but everything is connected. 1. The Fed Rate (FEDFUNDS dark purple) falls before unemployment rises and recession. Note that the market rose while the interest rate was at its peak in 2006-2007 and 2019. So a further interest rate rise in November shouldn't be a worry, not that it seems likely today looking at the CME Fedwatch Tool www.cmegroup.com 2. There are still more job openings than people to fill them (JTSJOL Non-Farm Job Openings minus USCJC US Continuing Jobless Claims - dark blue). Still unchanged since May. 3. Unemployment Rate (UNRATE dark gray) rises before SPX (yellow) drops. Currently UNRATE is up to 3.8% and unchanged August-September. Relatively static and close to multi-year lows. 4. Note that since May: * Initial Jobless Claims (USIJC light blue at the bottom) have dropped * Continuing Jobless Claims (USCJC light gray) are unchanged * Non-farm Payrolls (USNFP green) are unchanged * Job openings (JTSJOL light purple) fell slightly and rose back to the May level. At over 9m there are more available jobs that any time pre-COVID. * The number of Employed Persons (USEMP light pink) is rising continuously and is now at 161.5m - almost 3m more that pre-COVID. There's your economic growth. 5. After a year in decline, M2 Money Supply rose during the summer but might now be falling - a negative indicator? 6. The SPX drop last year was a result of inflation -> rate rises -> fear. But the recession didn't happen and the economy still looks strong Conclusion is that macro conditions still don't foretell a market crash in the immediate future. NOT TRADING ADVICE. DO YOUR OWN RESEARCH.
FRED:JTSJOL
by lavoriamo
Macro perspective on SPXFirst pane is SPX, no explanation needed here. Second pane is ICE BofA US High Yield Index Effective Yield (Performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market). Usually when it hits numbers above 9+ market is oversold and 10-week breadth/momentum indicator is awful. Now, that is not the case. Third pane is 10-week MA of MMTH Index (Percent of Stocks Above 200-Day Average). I use it as long-term momentum indicator. We might be just getting started our freefalling according to this. It's not so useful for timing purposes, but it lets you know where we are in a cycle. Apply other technical tools to take advantage of this data. Feel free to share your opinions and strategies.
FRED:BAMLH0A0HYM2EYShort
by Robert077
Long term gold.Long term entries and exits for 20 year bonds and SP500 (via SPY) in correlation solely to FED interest rates and US inflation rate adjustments. Here's my personal game plan going forward with this in mind- not war news. Starting to add TMF (20 year treasury 3X) equity now. ~Sell covered calls on it until FED pivot lowering interest rates. ~Add all TMF covered call profit to equity until FED pivot lowering interest rates. ~Hold TMF equity until the following FED pivot where they begin increasing interest rates again- no matter how long that may be. Last time, that took from Jan, 2020-Oct,2021. The time before that, was April, 2007- July 2015. As shown by the vertical blue lines on the interest rate chart, fed has previously held interest rates at 5.5% for years at a time. Specifically, from January, 1995 to April, 1998. Then, raising rates again in April, 1999 through October 2000. The tech bubble soon followed that.. If we are comparing things to then, and fed did get things right this time around and achieved the "soft landing," then we will see equities continue to do well as they did in 1995-2000. We would have potentially years worth of gains before reaching price to earnings levels anywhere near previous over valued levels... Where QQQ P/E ratio was a crazy 190 in March, 2000. Meanwhile, today, QQQ P/E ratio is 32.88. A huge fundamental difference. Which is even an 8% premium discount in relation to QQQ's 3 year average P/E today of 30.45 In 2000, 10 year bond yields reached 6.03% As of October 16, 2023, the 10 year bond yield was 4.71%. Showing previous radical levels include much more room for todays markets. Now., if we are comparing things to 2008 when banks were writing sub prime loans and simultaneously dealing with FED interest rates at 5.5%, the span that rates were that high was only from April 2006-April 2007. As sited to Forbes.com, "By early 2007, the housing bubble was bursting and the unemployment rate started to rise. With the economy failing, the FOMC started reducing rates in September 2007, eventually slashing rates by 2.75 percentage points in less than a year." In which that case we saw SPY equities lose 57% from October, 2007- March 2009. Worldly/economic conditions are clearly different today than in 2000 and 2008. Those are simply references from similar fiscal conditions where outcomes ultimately contradicted each other. To continue, from looking at past market reactions, I will ]continue holding TMF up until the point when FED pivots to begin increasing rates again. Subsequently, this will not happen until US inflation rate is below the 2% target goal. When US inflation is back down to 2% goal but not until, sell all 20 year bonds and start dollar cost averaging equal weight into: XLG- SP500 top 50 fund paying 8.5% dividend SVOL- Inverse vix paying 17% dividend TQQQ- QQQ 3X SOXL- Semiconductors 3X As for the current technical level of SP500 (SPY)...we are currently at the level going back to October of 2021. This is when market reacted to FED starting to increase interest rates again. To summarize, if fed were to raise rates again this coming November 1st, this support level will likely get bought up by the same buyers who bought in October, 2021 and January, 2023. Especially now that US interest rate is at 3.7% compared to the 6.7% it was in October of 2021. When you look at the reality of that, essentially the same SPY price today is 3% less inflated than it was 2 years ago at the crazy high covid spending levels. Adding that with the current P/E levels, I genuinely don't know if that is a fair value. One thing I'm certain of, big money knows. They clearly seem to follow the interest rate pivot decisions for market bottoms and tops. For 2024-2025, if FED lowers interest rates for any unexpected/surprising reason we haven't been notified of yet, equities price action absolutely would be on a path similar to 2000 or 2008. Essentially returning to pre covid levels. In return, bond yields would crash while the face value massively increases. Which is why my main play is TMF- leveraged 20 year bonds.
ECONOMICS:USINTR
by raylanboogie
The Potential Consequences for the U.S. Debt CrisisFrom zetalon.com The article by Ming Wong explores the significant financial consequences if the Overnight Reverse Repurchase Agreement (ON RRP) facility reaches a zero balance. Managed by central banks like the Federal Reserve, the ON RRP is crucial for controlling short-term interest rates and managing bank reserves. Following the trend depicted in the article, there could be a complete unwinding of ON RRP agreements by late 2023 to early 2024. This unfolding scenario would have several ripple effects: Short-term Liquidity Crunch: A zero balance in the ON RRP would severely limit short-term investment options, leading to a liquidity crunch. This would push up the demand for other short-term securities, subsequently increasing their yields. Impact on Broader Interest Rates: The rise in short-term rates would likely cause a shift in the entire yield curve, affecting medium to long-term rates. U.S. Debt Crisis: With a debt burden nearing $33 trillion, the U.S. would find itself under more pressure due to rising short-term interest rates, leading to higher debt service obligations and less fiscal flexibility. Foreign Creditor Dilemma: The increasing difficulty in servicing U.S. debt could reduce the confidence of foreign creditors, possibly leading to decreased demand for U.S. securities or even divestment. Credit Rating Risk: Credit rating agencies might reevaluate the U.S.’s creditworthiness, potentially leading to downgrades that would further increase borrowing costs. In summary, a complete unwinding of ON RRP agreements by late 2023 to early 2024 would not only lead to short-term liquidity challenges but would also escalate borrowing costs, disrupt fiscal policy, and diminish global confidence in U.S. financial stability.
FRED:RRPONTSYDShort
by HugoWong032
Market Cycle: BTC vs. ISM; (updated) BTC cycle low precedes the ISM cycle low by about 1 year, while the BTC and ISM cycle highs occur at roughly the same time within the market cycle. Presumably, the cycle highs are approximately coincident due to increased liquidity associated with QE? ISM is moving higher after the dip in June 2023. If the dip in June 2023 turns out to be the low for the ISM this cycle, then the 12-15 month measurement from the BTC low in December 2022 won't be valid this time around. I hope this is the case! However, there could still be some room (time between now and the 12-15 month mark) for a rapid dip in ISM before a recovery and build-up towards ATH. Let's see how this develops... This chart is a minor update of a previous version published on July 29, 2023: Updates Made: Added 12-bar measurement and gray shaded rectangle beginning at the most recent BTC low in December 2022. Also added orange 15-bar measurement and orange vertical dashed line.
ECONOMICS:USBCOILong
by SKYNETrader
A lot of moneyA lot of money: USM0 = 5,559,000,000,000 USM1 = 18,320,000,000,000 USM2 = 20,865,000,000,000 USMR = 7.9% US10Y = 4.935% These gradations are in decreasing order of liquidity. M0: Strictly coin & note currency in circulation plus commercial bank reserve balances at Federal Reserve Banks; M0 is often referred to as the "monetary base." M1: Includes M0 monies defined as the sum of currency in circulation, demand deposits at commercial banks, other liquid deposits and traveler's checks. M2: Is less liquid in nature and includes M1 plus savings and time deposits, certificates of deposits, and money market funds. M3: A measure of the money supply that includes M2 as well as large time deposits, institutional money market funds, short-term repurchase agreements (repo), and larger liquid assets. Often referred to as "broad money," which are more closely related to the finances of larger financial institutions and corporations than to those of small businesses and individuals. USMR: 30-Year Mortgage Rate is average 30-year fixed mortgage lending rate measured during the reported by week and backed by the Mortgage Bankers Association. US10Y: The U.S. 10-Year Bond is a debt obligation note by The United States Treasury, that has the eventual maturity of 10 years. The importance of the 10-year Treasury bond yield goes beyond just understanding the return on investment (ROI) for the security. The 10-year is used as a proxy for many other important financial matters, such as mortgage rates & credit card APR.
ECONOMICS:USM2
by Options360
VIX long term WAVE C down will be UGLY once wave B is topI think all should understand that I am looking for that last short squeeze in the markets and NOT by any mean a new Bull market . My view is based on DATA of 123 yrs NOT wishful thinking . way too many of you have not lived thru a true bear market I have lived thru 5 and this will be my 6th I have studied Every bear market I will warning all a second time this is the last leg up . and if you do not want to be holding on with loses for 3 to 5 years use the last wave up to take advantage of the yields in 2 yr paper or just stay in 30 to 90 tbills the return will be one as the market is going to drop .382 of the whole move up 1974 or 2009 both will be very painful
FRED:VIXCLS
by wavetimer
1
S&P 500 Gains on Positive Earnings OutlookThe S&P 500 index opened with a 0.8% gain on Monday, with investors focusing on upcoming third-quarter earnings reports from major companies, even as US Treasury yields have risen. Last week, the index recorded a 0.45% gain despite a significant sell-off on Thursday and Friday, partly caused by concerns about Israel-Gaza hostilities, leading to lower market closes. However, strong earnings from major banks like JPMorgan, Citigroup, and Wells Fargo supported the Dow Jones index. This week, the S&P 500 is expected to rebound as several major companies, including Johnson & Johnson, Bank of America, and Goldman Sachs, report earnings. Additionally, key events include US Retail Sales for September and a significant speech by Federal Reserve Chair Jerome Powell on Thursday. Dow Jones futures are leading the way, and all three major indices are in positive territory ahead of the opening bell. Based on technical analysis, the S&P500 slightly higher on Monday, pushing towards the middle band of the Bollinger Bands. Currently, the S&P500 is trading above the middle band, suggesting the potential for a higher move to the upper band of the Bollinger Bands. The Relative Strength Index (RSI) stands at 55, indicating that the S&P500 is back to neutral bias. Resistance: 4399, 4439 Support: 4353, 4317
FRED:SP500
by Think_More
US Govt Real Debt is Down Last 3 YearsThe "real value of the US Gov't Debt" is a different way of looking at our situation through rose-colored glasses, but it is a fair analysis. If we "adjust the debt level for inflation" as measured by the CPI Index (All Urban Consumers Index) from the beginning of the series back in 1966, you will have a line that is grinding SIDEWAYS since October 2020 at a reading of $105.9 Billion. The latest number was the July reading at $105.1 Billion which is a slight decline. All of this sounds like "hocus-pocus" but it is a fact that inflation makes it easier for the Gov't to pay off its debt in the new "cheaper valued" dollars. The dollar is the same, only there are far more of them floating around in the system so each of them is worth less. If we analyze how the US debt has increased relative to other countries' debt, we could also see how we are doing. The financial market's are open for analysts to find discrepancies between the value of various currencies and over time, the market adjusts for the amount of currency being created in an economy. We can look at the TVC:DXY or US Dollar Index to see how the US economy has fared versus its trading partners. The Dollar Index is weighted for the amount of trading between the various currencies. I can follow up on that analysis in the next chart. For now, we can at least see an optimistic chart about the actual "REAL" amount of debt that the US Gov't (which is US, the taxpayers) has over the last 3 years. Covid spending and lockdown payments to keep the economy afloat certainly launched us up into the stratosphere FIRST but since 2020 that debt has been in a sideways pattern.
FRED:GFDEBTN
by timwest
6
Reduce risk in portfolios without hampering returns Asset allocation is ultimately about balancing returns with risks. While it is relatively easy to reduce risk in a portfolio, it is harder to do so without diminishing its return potential. Diversification, that is, adding uncorrelated assets to the portfolio, is one of the main tools available to investors to lower such risk, but it often comes at the cost of returns. The 60/40 portfolio, a mix between 60% equities and 40% fixed income, is the bedrock of asset allocation for many investors. Adding fixed income to equities does lower volatility and improve the Sharpe ratio, in line with Markowitz’s findings in this Nobel Prize-winning work and due to the historically negative correlation between equities and investment-grade fixed income. However, it is also true that a 60/40 portfolio has tended to deliver lower returns than a 100% equity portfolio. Does it mean that investors have to choose between higher returns with increased volatility or lower returns with decreased volatility? Cliff Asness’ thought experiment: the levered 60/40 As with any problem, the solutions usually require out-of-the-box thinking. In our case, it requires to start thinking about leverage. Cliff Asness, co-founder of AQR Capital, provided such a solution in December 1996 when serving as Goldman Sachs Asset Management’s director of quantitative research with his paper ‘Why Not 100% Equities: A Diversified Portfolio Provides More Expected Return per Unit of Risk’. In his paper, Asness argues that investors can achieve competitive returns while managing risk more effectively by diversifying their portfolios with a combination of equities and bonds and using leverage. Asness designs the ‘Levered 60/40’ portfolio which leverages a 60/40 portfolio so that the volatility of the leveraged portfolio is equal to those of equities. The applied leverage is, therefore 155%. The borrowing rate used for leveraging his 60/40 portfolio is proxied by the one-month t-bill rate. In his original paper, Asness finds that, over the period 1926 to 1993, the Levered 60/40 portfolio returns 11.1% on average per year with 20% volatility. Equities, in contrast, return only 10.3% with the same volatility. For reference, the 60/40 portfolio (unleveraged) returns 8.9% with 12.9% volatility. We extended the Asness analysis to the most recent period. We observe that over this longer period, the results still hold true. The Levered 60/40 delivers higher returns than equities with similar volatility. The Sharpe ratio of the Levered 60/40 benefits from the diversification and is improved, compared to equities, with no cost to returns themselves. Leveraging the 60/40 around the world, a successful extension In Figure 2, we extend the analyses to other regions to test the robustness of such results. While the history is not as deep, Figure 2 shows similar results. Across all the tested regions, the returns and Sharpe ratio of the Levered 60/40 portfolio exceeds those of the equities alone. At the same time, the volatility is identical, and the max drawdown is reduced. Note that we do not use a 155% leverage in all those analyses; we use the relevant leverage to match the volatility of the equities in the region. Having said that, the leverage remains very similar across regions as it oscillates between 160% for global equities and 170% for Japanese equities. The theory behind the Levered 60/40 From a theoretical point of view, the idea of focusing on the most efficient portfolio possible and leveraging it to create the most suited investment for a given investor is well anchored in financial theory. When he introduced the Modern Portfolio Theory (MPT) in 1952, Harry Markowitz had already outlined the concept through the Capital Allocation Line (Markowitz, March 1952). The efficient frontier for a mix of 2 assets: US equities and US high investment-grade bonds. Note that each portfolio on the efficient frontier is the most efficient for a given level of volatility, assuming no leverage. All portfolios on the efficient frontier are not equal and have, in fact, different Sharpe ratios. Along this efficient frontier, there is a portfolio with the highest Sharpe ratio of all, called the ‘Tangential Portfolio’. This most efficient of all the efficient portfolios happens to be found where the Capital Allocation Line touches the efficient frontier. The Capital Allocation Line is the line that is tangential to the efficient frontier and crosses the Y axis (the 0% volatility axis) at a return level equal to the risk-free rate. When it comes to building the most efficient portfolio for a given level of volatility, investors have two choices. Without leverage, they can pick the portfolio with the highest return for that volatility level on the efficient frontier. If investors look for strategies with a volatility level equal to equities, equities are the most efficient portfolio. Considering potential leverage, the answer is quite different. With leverage, an investor can pick the portfolio with the relevant volatility level (in this case, the equity volatility) on the Capital Allocation Line. Portfolios on this line happen to have a Sharpe ratio equal to the Sharpe ratio of the Tangential portfolio (that is, the best Sharpe ratio of all the portfolio combinations without leverage) but with any level of volatility that may be required. We called the Leveraged Tangency Portfolio the portfolio on the Capital Allocation Line with the same volatility as the equity portfolio. This portfolio is a ‘more efficient portfolio’. The return is improved by almost 2% for the same volatility, leading the Sharpe ratio to jump from 0.27 to 0.45. Key Takeaways “Diversification is the only free lunch in Finance”, whether a real or fake H. Markowitz’s quote, epitomises the philosophy that underpins the 60/40 portfolio. It is also one of the main lessons from Markowitz's Nobel prize-winning work. Having said that, the second lesson has not been heeded as well: leveraging a good portfolio can make an even better portfolio. Overall, by leveraging a traditional 60/40 portfolio, an idea that, at WisdomTree, we call ‘Efficient Core’, investors could potentially receive a similar level of volatility present in a portfolio 100% allocated to equities but with the better Sharpe ratio of a 60/40 portfolio. Possible examples of where such Efficient Core portfolios may be used widely in multi-asset portfolios include: An equity replacement A core equity solution designed to replace existing core equity exposures. By offering return enhancement, improved risk management and diversification potential compared to a 100% equity portfolio, Efficient Core can also be used to complement existing equity exposures. A capital efficiency tool By delivering equity and bond exposure in a capital-efficient manner, Efficient Core can help free up space in the portfolio for alternatives and diversifiers. In line with the illustrations above, allocating 10% of a portfolio to this idea, investors would aim to get 9% exposure to US equities and 6% exposure to US Treasuries. This could allow investors to divest 6% from existing fixed income exposures and consider alternative assets (such as broad commodities, gold, carbon or other assets). In this scenario it could potentially be achieved without losing the diversifying benefits of their fixed income exposure. This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
FRED:GDPC1
by aneekaguptaWTE