Trading on Market Signals

How do investors translate market signals into successful trades? The Global Fixed Income and Foreign Exchange Strategy team at JPMorgan Securities identified seven bond market signals in four market-driving categories, tested their theories and combined the signals into a composite bull/bear index on the market known as the Bond Barometer.

Following are the seven signals by category and the trades they were tested on:

Two fundamental forces drive bond yields: growth and inflation. If you understand that bond prices are present values of future cash flows, then you know that forecasts of future growth and inflation are more important than historical data reports on what has already occurred.

Signal one: Market consensus for year-ahead GDP growth, as measured monthly in the Blue Chip survey of 50 professional forecasters.

Signal two: Market consensus for year-ahead inflation, as measured monthly in the Blue Chip survey of 50 professional forecasters.

Trade: Buy the 10-year US Treasury note when the consensus lowers its estimate of year-ahead growth and inflation, suggesting interest rates will go down and bond prices will go up. Sell the 10-year Treasury note when the consensus raises its estimate of year-ahead growth and inflation, suggesting rates will rise and prices will fall. Hold for one month until next consensus figures are released. Roll trade if consensus moves in same direction; reverse if consensus turns; close if consensus in unchanged.

Presuming that asset prices fluctuate around a stable, long-term equilibrium, extreme deviations serve as lead indicators of trend reversals.

Signal three: Real (inflation-adjusted) yields.

Trade: Buy the 10-year US Treasury note when real yields are more than one standard deviation above the long-term moving average sell when they are more than one standard deviation below. Hold the position until real yields cross the opposite threshold.

Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield.

Trade: Buy bonds when the ratio is more than half a standard deviation below its long-run moving average (bonds are cheap relative to stocks) sell when it’s more than half a standard deviation above its long-run moving average (stocks are cheap relative to bonds).

Risk appetite refers to investors’ relative preference for safe and risky assets, prompted by business cycle fluctuations, policy developments or exogenous events.

Signal five: JP Morgan Credit Appetite Index, where zero represents minimum appetite (widest spreads, positive for U.S. government bonds) and 100 represents maximum appetite (tightest spreads, negative for U.S. government bonds).

Trade: Sell U.S. government bonds when credit appetite is high, as signaled by the CAI being more than one standard deviation above its 50-day moving average, and buy when it is low, or more than one standard deviation below its 50-day moving average.

Technical indicators trace market patterns in price and volume.

Signal six: Price data.

Trade: Buy when the short-term moving average of prices crosses the long-term average from below sell when it crosses from above. In this momentum measure, the strongest returns were generated when short-term was 10 days and long-term was 20 days.

Signal seven: Flow data, defined as net purchases of U.S. bond market mutual funds, as an indicator of cash flow into the bond market.

Trade: Buy the 10-year Treasury when the flow indicator is more than one standard deviation above the long-term moving average sell when it’s more than one standard deviation below.

JP Morgan’s testing of their Bond Barometer showed that trading rules offer no holy grail, but they can exploit systematic relationships in the market. In addition, diversification pays no single indicator works at all times or in all trading environments. In the absence of foresight, a diversified strategy that combines different information sources (fundamentals, value, risk appetite and technicals), trading strategies (momentum and contrarian) and holding periods (daily, weekly and monthly) far outperforms narrower approaches over the longer term.

Consult your financial advisor if you want to discuss this information further.