Rule 2 — The Trend Is Your Friend
Background: Markets have long sought to generate alpha from policy developments. The 24/7 media cycle, turbo-charged by social media and algorithmic high frequency trading, accelerates execution cycles and generates information overload which complicates strategy formation.
This blog series articulates rules for designing news-related trading strategies. They apply across all asset classes and financial instruments. Posts include examples and concrete data.
That’s right…the same rule that works for markets works for policy risk and identifying key inflection points. It is the corollary to Rule 1 (Be Objective). Today’s post focuses on why policy risk is like market risk and how you can use this insight to generate alpha as well as effective hedging strategies.
Momentum Matters — Don’t Fight the Tape
The markets have an old, valuable maxim: “don’t fight the tape; the market is always right.” The point is that as a trader you don’t want to get caught on the wrong side of momentum. It does not really matter if the fundamentals or the technical are pointing in a different direction. If the market is heading somewhere, as an individual investor you cannot change the direction of travel so you either have to follow the trend (e.g., invest in an index fund) or get out of the way (hedge or divest). The efficient market hypothesis basically posits that all those other traders together cannot possibly be wrong; someone knows better and if you don’t see why the market is heading in a particular direction then you need at a minimum to get out of the way to avoid getting crushed.
Anyone who has spent a fair amount of time on Capitol Hill and within the policy process in Brussels, Basel, Washington, London, or any other center of policymaking knows that the same dynamic applies to the policy process. The momentum builds the closer one gets to a final decision or inflection point.
The challenge for market participants is that policy momentum looks and sounds different from market momentum.
Policy momentum moves more slowly than market momentum. And unlike the value-neutral numerical values that express market momentum, policy momentum is wrapped in values and unstructured data (words). If you are an advocate, a voter, or an impact investor, then you will want to pile in to support the direction you believe to be the correct outcome by creating a positive feedback loop for companies that take virtuous or preferred actions relative to a policy trend. But for everyone else, it is important to realize that you are a bystander in the process. You are not able to influence the outcome with your individual investment.
If you want to influence the outcome, become involved in the policy process. Write a comment letter when a consultation opens. Write an op-ed. Hire a lobbyist. Hire a pollster. Vote. But don’t confuse these activities with investment policy. Investment policy (except for impact investors) isn’t about changing and outcome or even supporting a good outcome. Investment policy is about making sure that you can generate alpha and/or hedge for downside risk even when you think that a policy trend is negative.
You Don’t Have To Like It
This is where Rule 1 (Be Objective) comes in handy. You don’t have to like the trend in order to identify it and invest accordingly. You just need to be able to identify it in order to trade effectively.
Case Study: CryptoCurrency Regulation
Consider the evolving cryptocurrency policy landscape. Many investors, issuers, and ICO issuers believe deeply that regulation of the blockchain/crypto universe is either unnecessary or inappropriate. You can believe this all day long, but if you are invested in the sector in any way you have a professional obligation to be aware when and how regulatory policy will impact the economics of your position.
In point of fact, momentum towards direct regulation of the crypto space has been building for two years.
- August 2017: The Basel Committee drops a major conceptual document regarding FinTech regulation while most people were on summer vacation. We spotted it HERE in August 2017.
- January 2019: The UK’s Financial Conduct Authority released a consultative paper proposing a regulatory framework for Initial Coin Offerings (ICOs) that would effectively keep some forms of cryptocurrency outside the perimeter of regulation. We analyzed that proposal HERE in January 2019, noting that the UK is now the outlier since other major jurisdictions (Singapore, Hong Kong, United States, Japan, Abu Dhabi and Qatar are taking a different approach.
- February 2019: Financial Stability Board policymakers released a trio of documents over a ten day period that, taken together, point towards increased regulatory attention to, and regulation of, the crypto space. We put the puzzle pieces together HERE and HERE.
- March 11–13: We identified HERE key policy issues for the cryptocurrency space associated with the new JPM Coin. By Wednesday morning (March 13), the Basel Committee on Banking Supervision had issued a statement making clear that any regulated bank either with exposures to the sector or with related services that operate in the sector is expected to have in place a range of risk mitigation policies and procedures including: due diligence, disclosure and notification to its regulators.
The trend towards increase regulation of the cryptocurrency space is clear and growing right now. Consider the penultimate sentence of the Basel Committee press release: “The Committee will in due course clarify the prudential treatment of such exposures to appropriately reflect the high degree of risk of crypto-assets.” In other words: bank regulators globally are starting to explore what kind of regulatory capital requirements should apply to bank exposures in this sector.
You don’t have to like this trend to realize that the Wild West days of low cost crypto-issuance are over.
Knowing that the trend exists is the first step towards crafting a serious strategy for hedging or delivering alpha.
What is true for the crypto space is true for every regulated sector on the planet.
We could write a similar timeline for any number of trade and tariff policy decisions which have been driving headline risk for the last 18 months. You don’t have to support increased tariffs on steel or, the UK, increasing the proportion of EU imports eligible for zero tariffs (from 80% today to 87% in a post-Brexit world) as reported by Reuters HERE to know that specific sectors (e.g., industrial manufacturing, soybean farmers in the United States, the auto sector) will be uniquely impacted by the policy shift.
Whether the trend is towards increased regulation or deregulation, the outcome is the same: the cost basis for delivering a product or service shifts with every change in regulatory policy. You do not need to agree with the shift in policy in order to position yourself strategically in relation to the shift. You just need to be able to maximize the advantage from the momentum, particularly if you owe a fiduciary obligation to your clients.
How To Deal With Momentum Shifts: Use the same process you would use if the relevant shift were a shift in the Dow. If you or your clients are invested in a sector and momentum starts shifting away from the status quo (in any direction):
- Reevaluate the position.
- Conduct scenario analysis for different policy outcomes.
- Identify potential hedging strategies to cover downside risks from a shift in policy.
If you are not yet invested when momentum to change policy begins to emerge:
- Start crafting investment theses that will position you and your clients to maximize first mover advantages.
- Identify the sectors most likely impacted positively and negatively from the anticipated policy shift.
- Assess the likelihood of a specific policy outcome becoming a reality within a specific time horizon (more on this in later posts), and invest/hedge accordingly.
FX markets and sovereign bond markets are usually the asset classes most directly impacted by macroeconomic and geopolitical policy shifts, but as this post indicates a much broader range of policies that operate below the level of front page news can deliver a material impact on individual economic sectors and companies.
If you are not actively assessing policy risk, you are exposed to risk from policy shifts anyway. You might as well assess your risk and develop a strategy to address those risks and related opportunities. The time to undertake analysis is when the momentum starts building so that you are not caught out by headline risk later when a decision is announced.
Conclusion: The trick, of course, is to identify in a timely way when momentum is building towards a specific outcome. This is the focus of Rule 3. Stay tuned.
Barbara C. Matthews is Founder & CEO of BCMstrategy, Inc., a technology company deploying patented and proven processes for measuring public policy risk and anticipating outcomes based on those measurements. You can find more information about the company here: www.bcmstrategy2.com. She has served as a senior policymaker and Senate-confirmed diplomat in the United States government as well as a senior strategist and advocate for the global banking industry. An earlier version of this article appeared on the Traders’ Insight blog hosted by Interactive Brokers.