In July, our Equity factor continued its healthy trend of positive performance, gaining 2.79% for the month, or 14.83% YTD. Four out of six beta-neutral equity style factors posted returns in the bottom 20th percentile of their history since inception of the Two Sigma Factor Lens, while Value managed to reverse its trend of negative performance.
Perhaps most interesting is that July ended with a central bank bang. In three consecutive days to end the month—the 26th, 27th, and 28th—we saw the Fed, European Central Bank (ECB), and Bank of Japan (BOJ) raise rates. This was expected for the Fed and ECB, but for the BOJ this move was out of the ordinary. Japan’s yield curve control (YCC) policy has typically left them as the odd country out when it comes to global interest rate increases (more on this later). Consistent with this theme of global rising rates, we saw our Interest Rates factor down -0.68% for the month.
Below we show the performance of the Two Sigma Factor Lens in July.
Exhibit 1: Two Sigma Factor Lens Performance in July
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 - July 2023
Value (and Quality): As mentioned in previous posts on bank failures and sectors, generally speaking, Value is typically long bank exposure whereas Quality is typically short. While there is likely more than banks explaining the dynamics between these two factors as of late, banks have certainly made headlines during the Q2 earnings season in the U.S. This is true for big banks but also regionals, with the latter showing healthier balance sheets than the previous quarter.1 More specifically, this included better than expected deposit levels.2 U.S. regional banks were up 15.6% in July.3
BOJ’s Yield Curve Control Policy: As a quick refresher, beginning in 2016 the BOJ set out to keep Japan’s short-term interest rate at -0.1%, with the 10-year around 0.0%. Why? Per a Reuters report, “After years of huge bond buying failed to fire up inflation, the BOJ cut short-term rates below zero in January 2016 to fend off an unwelcome yen rise….To pull long-term rates back up, the BOJ adopted YCC eight months later by adding a 0% target for 10-year bond yields to its -0.1% short-term rate target.”4
This made Japan’s yield curve fairly consistent over the last year as global yield curves changed around it, an occurrence that affected a variety of investment strategies and the flow of money. As previously discussed, this dynamic has also been affecting positioning/performance of various Venn factors such as Foreign Exchange Carry, Foreign Currency, and Fixed Income Carry.
On July 28th, softer language was used by the BOJ to relax the bands around the 0.0% 10-year target to be a “reference” rather than a “rigid limit”.5 However, the effects of this change were priced into currency markets much earlier than the 28th. This is partially evidenced by an article in the Financial Times6 discussing the possibility of a change to the YCC policy; written during a rally in the Yen from July 5th–July 13th.7
Exhibit 2: YTD USD/JPY Exchange Rate
Source: Venn by Two Sigma, Bloomberg
Our risk factors also responded to this move in the Yen as our Foreign Currency factor (long Yen) and our FX Carry factor (short Yen) moved in opposite directions, returning 3.57% and -2.58% respectively over the period (Exhibit 3).
Exhibit 3: Foreign Currency and FX Carry Factor Returns, July 5th–July 13th
Source: Venn by Two Sigma
In the last two trading days of July when the cap was actually relaxed on the 10-yr Japanese government bond (JGB), we saw a more than 15 bps jump in its yield. Due to the relatively attractive term spread of the Japanese yield curve relative to other major countries,8 our Fixed Income Carry factor’s largest long position was in fact the 10-yr JGB. Our FI Carry factor experienced a performance drag of more than -1.50% attributable to its JGB positioning in the last two trading days of the month.
Exhibit 4: 10-Yr JGB Yield in July
Source: Venn by Two Sigma, Bloomberg
If the BOJ continues to loosen its YCC policy, or eventually discontinues it, there could be significant global impact affecting carry, currency, and other systematic risk factors.
3 Regional banks measured by the iShares US Regional Banks ETF (IAT).
7 It’s also worth noting that this period led up to the U.S. inflation print, where a favorable result would potentially signal to markets a slowing of the U.S. rising rate cycle. This was happening alongside a market belief that the BOJ was thinking of changing their YCC policy to be more relaxed, which together may have caused potential strength for JPY versus USD over this period.
8 Countries considered include Australia, Japan, U.K, Canada, Germany, and the U.S.
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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