Inflation Regimes And Equity Correlations

Inflation of balloon from a system of aeronautics (1850) by John Wise (1808-1879)

About a year ago we wrote about Inflation Regimes and Return Distributions. The piece referenced an excellent chart we first saw from Goldman Sachs showing the Equity/Bond correlation vs realized US CPI. The negative correlation in the period since the late 1990s occurred in a world of low and stable inflation. The prior period in the chart, from 1970 to 1998 showed a period of higher than target inflation and a steadily positive correlation of stocks and bonds. Many portfolio strategies have been built with this negative correlation as the bedrock. It worked as the dual mandate acted like a single mandate on unemployment- the inflation side of the mandate could be safely ignored. Economy weakens, equity markets weaken, Fed cuts rates, bonds rally. Became self-fulfilling for a long period of time.

When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.

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As We See It: Yen Intervention Update

Around this time last year we wrote here on currency intervention in the Japanese Yen. The TL;DR version.

There is a pretty simple reason we don’t see intervention much anymore – it does not work…Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give.

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Dirty Portfolios – James Bond(s) Version

A few months back we introduced the concept of “Dirty Portfolios”, that add Managed Futures to traditional asset mixes the same way one adds olive juice to a martini to get the infinitely preferable dirty martini. That piece looked at a variety of popular asset allocation approaches and showed that adding Managed Futures improved returns, reduced volatility and drawdowns. It can be found here and has a lot of background info worth reading if you missed it – and apologies in advance for the tortured Dirty Harry quotes.

We received a lot of good feedback! One note we received a few times; “You guys looked at a lot of stock heavy asset allocations, but what about us fixed income investors. Can Managed Futures help diversify here also?”

In keeping with the movie references, here we take a look into fixed income and “license to kill” James Bond(s) quotes. Luckily, he liked a martini already, so we are halfway there. With the Spectre of high inflation causing a SkyFall in fixed income, could portfolios have been neither shaken nor stirred? (Sorry)

A Brief History Of Bond Yields

Sean Connery’s Dr. No hit screens in 1962. The US 10-year yield was right around where it closed 2022, 3.9%. Bond yields and Bond films peak at the same time with For Your Eyes Only in the early 1980s. 14 years later, as Timothy Dalton took over, yields were still high at 8.3%. As Pierce Brosnan pulls on the tuxedo they are 6.0%, as Daniel Craig takes over, 4.6%. In particular, this past 40 years or so have been incredibly good for bond portfolios, as yields reached what looks to be a nadir early in the pandemic at 0.5%. (We’ve ignored Lazenby because…well it was just one movie. Really good one though). Additionally, taking some poetic license, “The Brosnan Years” will be referred to as “The Best Years” for the remainder of this piece.

Source: Bloomberg (US Generic Govt 10 Yr), Mount Lucas

Since the premiere of the latest (last?) movie, No Time to Die in September 2021, the Fed has raised rates 450bps. In 2022 fixed income markets, there was no place to take (A Quantum of) solace. The Bloomberg US Agg Total Return Index returned -13.0%, the largest annual loss in decades. Managed Futures strategies performed well; as a proxy, the MLM Index EV (15V) returned 36.7%. Managed Futures strategies have a habit of doing well when other markets struggle, as it tends to hone in on the factors causing distress. 2022 was no different. The year was characterized by war in Ukraine driving commodity prices higher and high inflation causing interest rates to rapidly rise from pandemic induced lows, which in turn contracted earnings multiples in equity markets. For those parts of the bond markets with credit components, spread expansion added to the duration woes. Emerging market fixed income also suffered.

For the fixed income allocator, the benefit of Managed Futures strategies is that they can be positioned either long or short directly in fixed income markets. Managers typically trade a wide variety of global bond markets at different points on the yield curve and utilize leverage. This means you don’t need to add a very large amount of the strategy to a Fixed Income portfolio to see meaningful benefits, and at the top portfolio level the Managed Futures portfolios work to move around the entire portfolio duration systematically. Managed Futures strategies also get exposure directly in other markets impacted by fixed income prices – commodity exposures participate in inflationary and deflationary themes while currency markets are often expressions of relative interest rates. Indeed, in 2022, the shorts in the Japanese Yen and longs in the oil complex helped generate returns. Over the longer term, Managed Futures strategies are uncorrelated to fixed income markets, adding uncorrelated elements to portfolios improves risk adjusted portfolio returns.

Source: Bloomberg (US Treasury Total Return Index), Mount Lucas (MLM Index EV (15V))

Portfolio Allocation – The Dirty Answer

As we did in the last piece, here we try and answer the main questions on how to use Managed Futures. How much should someone allocate? Fixed income markets are not all the same, ranging from short duration US Treasuries to long duration emerging market or high yield corporate bonds. The “right” amount of a Managed Futures allocation we think would vary depending on the type of fixed income portfolio. Different risk profiles and different asset mixes lead to different answers. We think that even the most risk averse portfolios could benefit from some amount of Managed Futures. Below we show the addition of Managed Futures to some different sectors of the Fixed Income markets, creating a “Dirty” version. As parts of the Fixed Income markets are newer than others, some of the portfolios go back farther than others. Data runs through the end of 2022. For the Managed Futures exposure we use a combination of the original MLM Index (15V) and the MLM Index EV (15V), as we believe it to adequately represent the space in a passive fashion. Portfolios are rebalanced monthly – if you want to Die Another Day…rebalance.

Summary Data

The table below shows the summary total return data over different time periods. Generally, higher total returns, lower drawdowns, similar to lower levels of volatility and much improved in 2022. Optimized solutions look for meaningful Managed Futures allocations – 20-50%.

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Managed Futures – 2022 Review


2022 was a banner year in the Managed Futures space. Stocks and bonds both had a tough time, something that’s fairly rare. The S&P 500 Total Return Index returned -18.1%, the Nasdaq-100 Total Return Index fell -32.5%. The Nasdaq saw its high for the year on the opening day and the low a couple of days after Christmas. The Bloomberg US Agg Total Return Index returned -13.0%. The chart below illustrates how infrequent negative returns are in both asset classes.

If there was a year when a strong Managed Futures return would be most helpful, 2022 was it.

Below we will examine how investors use the asset class and review the key drivers of returns last year. We will then analyze the various quantitative approaches to trend following, how they explain dispersion among managers, and how they have performed historically and in 2022, when needed most.

Overview – Managed Futures

Many investors look at Managed Futures through a lens of absolute returns over economic cycles, uncorrelated to stock and bond markets. This lens looks at the broader range of markets available in Managed Futures – currencies and commodities typically – and both the long side and short side of return distributions available such that one isn’t reliant on prices always going up to generate positive returns. Either up or down is fine, as long as prices trend. Choppy sideways is bad.

Other investors look for Managed Futures as ‘Crisis Risk Offset’ strategies that they expect to generate returns during equity market declines and recessions, somewhat akin to put options or highly rated government bonds. This lens sees Managed Futures as capitalizing on flows that recessions and panics tend to coincide with – equity markets down, commodity markets down, flight to quality dynamics in currencies and fixed income.

In 2022 Managed Futures certainly delivered on both these counts, providing uncorrelated returns in the worst 60/40 market in decades.

In Part 1, we use the MLM Index EV methodology to examine how Managed Futures generated returns in 2022, looking in detail at the underlying market moves by asset class, highlighting some individual positions that contributed, and showing how some of the different approaches to Managed Futures impact returns. The MLM Index EV does a fine job at explaining and capturing the beta we believe exists in the space and using some different derivations in the parameters can offer some insight, particularly in big, interesting years.

In Part 2, we deconstruct Managed Futures returns into their contributing factors. Performance dispersion for any given Managed Futures strategy is generally driven by some combination of the following approaches by each manager:

  • Volatility – the level of overall strategy volatility that is expected or targeted
  • Trading speed – short, medium, long or blend lookback
  • Trend approach – simple moving average, slope, crossover, breakout, etc.
  • Market universe – more markets, less markets, alternative markets, sector allocation
  • Position/Risk management – how positions are sized, rebalanced, and volatility adjusted

Of course there is more going on, but in the same way equity indices can be constructed to target different styles or factors like growth/value, low volatility or by sectors, Managed Futures returns can be somewhat deconstructed along the lines above. It can be useful to take a look in detail at how each of the changes impacts the nuances of Managed Futures results.

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Inflation Regimes And Return Distributions

Below is a great chart from Goldman Sachs. It shows the low or negative correlation between stocks and bonds we have seen over the past few decades has been in part attributable to the low inflationary regime over the period. This makes perfect sense given the way monetary policy has operated over the last twenty-five years, counter cyclical policy is very effective in periods of low and stable inflation. When equity markets start to become concerned about recessions ahead, earnings expectations reduce and valuation multiples contract. Stock prices fall. Bond markets typically would then anticipate the increased chance of the standard monetary policy response; cutting interest rates to spur economic growth. Bond prices rise. That explains the light blue dots below. The dual mandate was really a single mandate on unemployment, as the inflation side of the mandate was not biting.

On the other hand, periods of higher inflation have historically resulted in positive correlation between stocks and bonds, represented by the dark blue dots above. During periods of higher inflation, you tend to see rising interest rates, knocking bond prices down and putting pressure on equity multiples. It is much harder for monetary policy to operate in higher inflation environments to combat slowdowns, as the option of cutting interest rates is less easy. The two sides of the dual mandate are in conflict.

Sounds a bit like 2022. High inflation led to a more rapid rise in interest rates than expected, doing a lot of damage to long term bonds that were trading at very low levels – the US10 year ended 2021 at 1.50%. Equity valuation multiples were repriced lower as rates went higher. Stocks and bonds both went down. Portfolios built using bonds to diversify stocks, sometimes with leverage, saw some of the worst returns in decades.

While the long side of the return distribution has dominated since 1998, a return to higher inflation expectations, as seen from 1970 to 1998, requires the investor to consider the other side of the distribution when considering diversifying strategies.

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Dirty Portfolios – Managed Futures As A Portfolio Element

Most investors know and understand the traditional 60:40 portfolio of stocks and bonds. There are many other model portfolios, with clever names and metaphors, out there blending different weights and different assets. Almost all benefitted from the low rate, low inflation market environment. So far, 2022 has been difficult across the board for these models as stocks, US Treasuries, and credit have all fallen, and even short-dated bonds have not helped.

To keep things interesting, we illustrate the role of Managed Futures in the portfolio below while having a bit of portfolio naming fun. We start with several of the more popular asset allocation models and garnish them with some Managed Futures. The same way adding an olive to a martini makes a dirty martini, can we enhance a classic by adding a Managed Futures “twist” and creating a “dirty” version? Apologies in advance as we then torture the ‘dirty’ reference with Clint Eastwood quotes.


The primary role of Managed Futures strategies is to diversify the portfolio, and allocators should always strive to evaluate those strategies under that context. When accessed through a pure trend following approach, Managed Futures offers an uncorrelated, positively skewed portfolio element with a positive expected rate of return that can complement the broader portfolios of equities, credit, and real estate.

The risk premium earned by investors participating in Managed Futures inherently has a different driver than equity markets. Think simply about how Goldman Sachs is structured. The investment bank side raises money for everything from companies to municipalities through equity and credit underwriting. The other side manages trading desks to facilitate the risk transfer of exogenous operational price risks that impact the running of a business. Both are risk premiums that companies face; markets exist to transfer them to investors. These two risk premiums are complementary, but they need to be accessed differently. One funds economic activity by investing in equity and credit securities from the long side, directing capital to those who seek to expand and transfers their capital risk. The other takes on exogenous input and output cost risks in commodity prices, currency movements, and changes in interest rates, facilitating hedging that allows businesses more price certainty in operations while focusing on their core expertise. Crucially, this risk premium needs to be accessed from both sides of the market: trend following long and short. The combination of the two risk premiums is very attractive, as one side thrives on stability and rising growth, while the other thrives in times of economic uncertainty and macro volatility that typically hurts equity and credit investors.

Put simply, where the investor premium in equity and credit markets looks for cash flows, the investor premium in the futures markets looks for “crash” flows.

Portfolio Allocation – The Inflation Problem

Traditional portfolio construction generally assumes holding long positions in different asset classes and relying upon low asset correlations to build better portfolios. Over the last few decades, an environment of declining bond yields and low inflation meant that, generally speaking, bond prices would rise any time stock markets fell meaningfully. As markets began to price that, in the event of any serious economic slowdown or episode of poor market functioning, the Federal Reserve would come to the rescue and cut rates. Somewhere during the pandemic this reached a nadir on two fronts. First, bond yields in developed markets reached such low levels that price appreciation on bonds became difficult to envisage. Take a typical 10yr bond with a duration of 8 for example. Starting at 400bps yields and dropping to 200bps would make 16% (simplified for ease). With yields bouncing around 50bps, it is hard for long dated yields to move meaningfully lower. Second, the stock bond correlation of the past 40 years generally relies upon inflation being reasonably low and steady. When inflation is notably higher, the economic link between stocks and bonds starts to break down as the Fed is less willing to reduce rates. Welcome to 2022 – both stocks and bonds have fallen. Those that use leverage to increase the risk profile of stock and bond portfolios have been particularly hurt. Sometimes bonds can diversify stocks, sometimes bond price falls can be the driver of what is hurting stocks.

For the portfolio allocator, the benefit of adding Managed Futures is that it can be either long or short different assets, giving it the ability to adapt positioning across different market regimes, including getting short bonds early this year. How long does the current regime last? No one knows, but as a portfolio element (2022 through the time of writing at the end of Q3), Managed Futures has diversified stock and credit portfolios pretty well, similar to the experience of previous crises in 2000 and 2008 (albeit those were deflationary, not inflationary).

Portfolio Allocation – The Dirty Answer

Yet, decades of complacency have left portfolios underexposed to investments that have historically done well in times of price uncertainty and volatility, and ill-equipped to handle the current market environment. For the allocator looking for exposure to these factors, several questions come to mind when considering Managed Futures. How should they be used? What allocation should they get? Great questions. The tough part- the answer is, as always, client driven. Where you stand, depends on where you sit. Different risk profiles, different asset mixes, different goals lead to different answers on what is right. Returns? Drawdowns? Volatility reduction? All fine ways to frame the approach.

To answer some of these questions, and to prioritize how typical investors allocate capital, we show the addition of Managed Futures to some typical portfolio allocations, creating a “Dirty” portfolio. As many of the portfolios have different asset mixes for which data isn’t always readily available, some go back further than others. Data runs through the end of Q3 2022. For the Managed Futures exposure we use the MLM Index EV (15V). We believe it to adequately represent the beta in the space while having some features that make it particularly useful as a diversifying portfolio element. In short, the MLM Index EV (15V) doesn’t contain equity markets, it does not adjust position sizes for volatility, and it passively represents the beta to pure trend following.

The analysis below uses common interpretations of each portfolio approach and represents them with total return building blocks, shown on a monthly rebalance schedule. Do not underestimate the importance of rebalancing in an asset allocation with uncorrelated, volatile components- closest thing you get to a free lunch in finance.

Summary Data

Much as we like the details and minutiae – some folk want to cut to the chase. What happens when you add Managed Futures to popular portfolios and make a dirty version? The table below shows the top-level stats over the time horizon, as well as 2022 and the Managed Futures allocation an optimizer wants. Portfolio allocations are sourced from and re-created with representative asset class indices.

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Correlations, Risk Parity and Trend Following

It is a common refrain that, in a crisis, asset price correlations move towards 1. What was once independent is no longer so, as a large common driver has emerged creating large and often forced flows from leverage unwinds and VaR models that then feed on themselves. This is shorthand – what really happens is correlations move to extremes.

Over the past 40 years or so, generally speaking, stocks and yields have been positively correlated. There were a couple of short-lived hiccups around the taper tantrum and early 2007 which soon reversed. In previous periods of stock weakness, you can see the correlations move decidedly higher.

Source: Bloomberg, Mount Lucas
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As We See It: Yen Intervention

The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

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As We See It: Small Markets

Right to the Source ….

The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.

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