‘Macro hedge funds may use Macro Arbitrage as a ‘remedy’ for their recent problems’

What is the cause? Macro hedge fund strategies are based on detecting macroeconomic trends which pre-empt trends in the markets.

No matter how good their tracking record, they have problems if markets confront adverse circumstances by remaining directionless.

A further problem develops if central banks act to maintain for various reasons a mispriced currency in conflict with macroeconomic fundamentals.

Even if the currency is mispriced, it can continue to stay so for quite some time if central banks are willing. Those betting on a correction back to macroeconomic fundamentals could end up with a failing strategy for a painfully long period of time.

A recent bet on the weakening of over-expensive sterling would have only worked because the Bank of England openly encouraged pound weakening in its statements rather than acting against it in the markets.

Some big macro hedge funds faced problems this year as markets traded in a range in the first quarter. Then the markets jumped, only to continue trading sideways all over again in the second quarter.

This contrasts vividly with the upward-trending markets of 1996-97 before the Asian crisis when performance among macro funds was excellent.

Although macro hedge funds are not trend followers, they need to be able to grasp one direction or another to implement their macroeconomic thinking, despite the availability of certain micro strategies. How can global macro investment styles do better in trying circumstances?

Besides trying to second-guess the central banks and focus on the direction of indices and currencies (for liquidity reasons), there are intermediate market levels between the macro (stock index level) and micro (stock level) which are not exploited in global macro investment strategies.

Relations between sectors, stock indices or baskets of stocks which have not caught up with their underlying macroeconomic reality, represent opportunities for macro arbitrage.

Combining macroeconomic fundamental and quantitative analysis with technical analysis, one can time the triggering of such new macro trading (short term) and investment (medium to long term) opportunities.

To take one example, the performance of construction stocks relative to building materials is controlled by GDP growth.

However in the UK, after the last recession due to lack of consumer confidence following a tough time, this cyclical spread did not price in GDP recovery for some while.

This provided an opportunity for a medium-term macro arbitrage investment opportunity to buy construction stocks and sell building material stocks.

In another example, banks' relative performance versus utilities is affected by the difference between the long bond yield and the level of short-term interest rates, as expressed via yield curve steepness.

This is so because banks' revenues depend on the differential between the rate at which they borrow and the rate at which they lend, whereas utilities are traditionally invested in long bonds given their receipt of regular cash flows.

Gabriel Burstein ''Macro hedge funds may use Macro Arbitrage as a ‘remedy’ for their recent problems'

Right now, in the eurozone, this relationship is mispriced, offering the opportunity to buy banks and sell short utilities against them while simultaneously selling Eurobond futures and buying Euribor futures.

During market dislocations, following last year's global financial crises, or after the announcement of unexpected economic numbers, markets take their time to price correctly relations between sectors and stock indices even though the market's overall direction does respond immediately.

The recent good manufacturing orders numbers in Germany left consumer goods stocks mispriced with respect to other manufacturing stocks, given that their orders increased faster than the total manufacturing orders.

This provides a classic macro arbitrage opportunity: to buy consumer goods manufacturing stocks and sell the rest of the manufacturing sector short.

Macro hedge funds may use macro arbitrage as a "remedy' for their recent problems due to depending solely on market trends and subjective macroeconomic views.

Or else one can diversify by capitalising on objective macroeconomic mispricings in sector and stock index long/short spreads.

This article appeared in the Financial News on July 26 1999.

© Copyright Financial News 1999.

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