01 Oct Learning From PIMCO's "Trend-Following Through the Rates Cycle"
Absolute Momentum strategies have the potential to generate positive returns across all interest rate environments, including a rising interest rate environment.
In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.
“Figure 1” in the paper (reproduced below) compares hypothetical excess returns of a simple trend following strategy model with those of US Equities and five year note futures from 1962 to 2014. The 14 years in which rates fell 100 basis points (bps) or more had the strongest trend following returns, averaging 10.3%. However, the 12 years in which rates rose 100 bps or more still had a positive average excess return of 4.5%. This should be compared with the -4.9% estimated excess return on Treasury futures during those years. Interestingly, equity markets had excess returns of about 6% in all three interest rate regimes.
Rising rate years are the most informative to examine further, as these are when generating positive returns is generally most challenging… Trend-following returns are typically back-loaded: The model tends to lose money initially upon entering a period of rising rates, but once a new trend is identified, positions switch and may profit. The years 1979, 1994 and 2009 were the exceptions over this sample. In each case, whipsaw in the equity market led to losses.
Three periods are worth examining closely. In the five year period from 1977 to 1981, five year yields rose 100 bps or more in each year. In 1977, the trend follower initially lost money, but then profited strongly as the trend persisted.
In the second example, 1994, yields moved too fast for the trend follower to profit, and whipsaws in equity markets led to negative returns.
In the third example, 2013, yields again moved too fast for the trend follower to catch the move and profit, but other asset classes, notably equities, did display significant trends, potentially delivering overall positive returns for the strategy.
PIMCO then concludes by saying:
Unanticipated periods of rising rates may have unpredictable results on multi-asset portfolios and on some popular strategies. No strategy can fully mitigate this, but we find that trend-following strategies do have the potential to exhibit fairly robust returns during such episodes thanks to their ability to take short positions in markets that are falling. Trend following, by its nature, tends to miss market turning points, and may lose money initially on spikes in rates or in periods of volatile but range-bound rate moves. However, our analysis shows that over extended periods, trend-following has the potential to perform strongly in all phases of the rates cycle, with contributions to that performance coming from all asset classes.
Research Paper: Trend-Following Through the Rates Cycle
Authors: Graham Rennison, Matt Dorsten, Vineer Bhansali