In many ways, February continued trends that have become all too familiar. Our Equity Factor fell alongside Interest Rates (long currency hedged global bonds), but with the drop in Interest Rates proving to be relatively more meaningful from a historical perspective.
While negative performance for our Interest Rates Factor has been a solid indicator for the significant increases in rates around the world,1 less obvious are the effects that rising rates have on cash. Even less obvious still is how those higher cash rates in turn affect the factor premiums we observe globally. This was especially true for Fixed Income Carry in February, a standout factor that performed in the 96th percentile of its historical returns.
Exhibit 1: February 2023 Risk Factor Performance
Source: Venn by Two Sigma. The median and percentile columns measure the performance of each factor in the Two Sigma Factor Lens relative to the entire history of the factor in USD, using monthly data for the period March 1995 - February 2023
Cash is King
Our Two Sigma Factor Lens keeps track of cash considerations. For example, both our Equity and Interest Rates Factors subtract out the local risk free rate from their returns, helping to isolate the true premium being captured.
For Factors like Equity, this cash consideration is very straightforward. For others, cash requires an additional layer of examination. Take, for example, our Fixed Income Carry Factor, which goes long relatively high yielding 10-year sovereign bonds and short those that are lower yielding.2
Looking at 10-year yields as of 2/28/2023, you might think certain long and short positions are obvious, such as long U.S.10-year bonds and short Japanese government bonds (JGB). After all, the U.S.10-year is yielding 3.42% more than the Japanese 10-year.
Exhibit 2: Yields on 10-Year Government Bonds
Source: Bloomberg as of 2/28/2023
However, once we account for local cash rates via the local 3-month T-bill, we see that the term spread of Japan has become more attractive.3 In fact, among the countries considered in our Fixed Income Carry Factor, the U.S. currently has the least attractive term spread, while Japan has the most attractive.
Exhibit 3: Term Spreads by Country
Source: Bloomberg as of 2/28/2023. Term spread measured by respective countries 10-year yield minus the 3-month yield
Yield Curves and Central Bank Policy
When it comes to evaluating how to implement carry strategies, yield curves are key. While not all government yield curves are inverted, most have significantly flattened amid rising rates and market uncertainty, leading to falling term spreads. The carry attractiveness of an asset is ultimately determined by this term spread. But what about Japan has kept its term spread so favorable?
The BOJ currently implements a Yield Curve Control Policy that targets short-term rates at -0.1% and a cap on long-term rates of 0.50%.4 This unique policy has caused Japan to maintain an attractive term spread relative to the rest of the world as shown in Exhibit 3. This affects positioning for our Fixed Income Carry Factor, which compares term spreads on a cross-sectional basis. In fact, our factor went from a short to long position in the JGB around November 2022 and has been long ever since.
Notable Fixed Income Carry Positioning in February
Getting more specific, in February our Fixed Income Carry Factor (before residualization against Interest Rates) benefited from short positions in 10-year bond futures for the U.S., Canada, and the U.K., which together contributed close to 6% in positive return.
A long position in the JGB neither helped nor hurt the Fixed Income Carry Factor in February, despite global bonds struggling for the month. It is reasonable to expect negative contributions to return from the long book amid rising rates, but given the central bank policy in Japan, JGB positioning was resilient for the long book in February.
Exhibit 4: Change in Yield for 10-Year Bonds and Contribution to Return for Fixed Income Carry in February
Source: Venn by Two Sigma as of 2/28/2023
2 Our Fixed Income Carry Factor is duration neutral and considers both term spread as well as a roll down component from 10 to 7 year maturities. It is residualized against our Interest Rates Factor.
3 Term spread= respective countries’ 10-year yield minus the 3-month yield
References to the Two Sigma Factor Lens and other Venn methodologies are qualified in their entirety by the applicable documentation on Venn.
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