The Great Fiscal Experiment: What could be next? - AlphaSimplex Group
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The Great Fiscal Experiment:
What could be next?
Kathryn M. Kaminski, Ph.D., CAIA®
Chief Research Strategist,
Portfolio Manager
Saurabh Kelkar, M.F.E.
Junior Research Scientist
April 2021
Page 1April 2021
Introduction
As a trend-following manager, we watch and follow where the market moves. The markets
sure have moved since last year, particularly after the COVID-19 crisis. A few interesting
themes stick out, leading us to wonder where the world may be going next. First, we discuss
some of the recent trends: the potential demise of the long bond trend, a powerful reflation
trade, and the shift from monetary to fiscal policy. Then, we review how the use of massive
government stimulus, or what we term “the great fiscal experiment,” may provide new
opportunities going forward.
RIP Long Bond Trend?
Few investors remember a rising rate environment. In fact, the bond market hit its bottom in
1981–1982, long before many of the current money managers were involved in the market.
Since then we have seen a long and steady ride to almost negative rates, in an almost 40-
year bull market for bonds. Through this period, there have been some indications the tide
would turn, but there was no yield bottom in sight. To put this into context, Figure 1 plots
trend strength for fixed income since 1981. This chart shows that short bond signals have not
been common since 1981, and have become even more uncommon in the period of
quantitative easing post-2008. It is also notable that bond trends moved to net short in
February of 2021.
Fixed Income Trend Strength Long/Short
(1980–Present)
6
Net Long
4
2
0
-2
Net Short
-4
Quantitative Easing
-6
1980-Nov
1985-Nov
1990-Nov
1995-Nov
2000-Nov
2005-Nov
2010-Nov
2015-Nov
2020-Nov
1984-Mar
1989-Mar
1994-Mar
1999-Mar
2004-Mar
2009-Mar
2014-Mar
2019-Mar
1983-May
1988-May
1993-May
1998-May
2003-May
2008-May
2013-May
2018-May
1982-Jul
1987-Jul
1992-Jul
1997-Jul
2002-Jul
2007-Jul
2012-Jul
2017-Jul
1980-Jan
1981-Sep
1985-Jan
1986-Sep
1990-Jan
1991-Sep
1995-Jan
1996-Sep
2000-Jan
2001-Sep
2005-Jan
2006-Sep
2010-Jan
2011-Sep
2015-Jan
2016-Sep
2020-Jan
Figure 1: Trend strength using a representative trend-following system for fixed income since 1980. Trend strength
is defined as the average trend signal across a basket of available bond futures. Trend strength is calculated daily
and then aggregated to a monthly mean. Data is from January 1980 to March 2021. Past performance is not
necessarily indicative of future results. Source: Bloomberg, AlphaSimplex.
Figure 2 plots trend strength in fixed income from January 2019 to March 2021. Bond yields
fell substantially in 2019, creating a strong long bond trend. This trend waned late 2019 into
2020 but it picked up steam again in 2020 as the COVID-19 crisis hit. Finally, towards the
end of 2020, the bond trend began to weaken substantially and finally turned net short in
February 2021 as markets grew more concerned over rising longer-term rates.
Page 2April 2021
Fixed Income Trend Strength Long/Short
(2019–Present)
6
Global yields race to zero The COVID-19 Crisis Net short signals
5
4
Net Long
3
2
1
0
-1
Net Short
-2
-3
Figure 2: Trend strength using a representative trend-following system for fixed income from January 2019 to March
2021. Trend strength is defined as the average trend signal across a basket of available bond futures. Trend strength
is calculated daily and then aggregated to a monthly mean. Past performance is not necessarily indicative of future
results. Source: Bloomberg, AlphaSimplex.
Since trend followers trade across asset classes, both the absolute level of a trend signal and
the relative contribution of any particular asset class is important. From this perspective,
something else stood out in 2020 for fixed income. Despite being the strongest trend in 2019,
fixed income hit some of its lowest relative weights in the last 10 years by the end of 2020
and going into 2021. To demonstrate this, Figure 3 plots the risk allocation by asset class
from January 2019 to present. Fixed income took up a larger amount of risk in 2019 and
eventually dwindled down to a small risk allocation in the beginning of 2021.
Risk by Asset Class
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Stocks Fixed Income Currencies Commodities
Figure 3: The risk budget information shown above represents the asset-class risk budget of a representative account
of the AlphaSimplex Managed Futures Strategy. These risk budget estimates reflect positions in derivatives (such as
futures and forward contracts), but exclude cash investments in money market instruments. Percent of risk budget
estimates are based on trailing 1-month volatilities (standard deviation) of daily instrument returns as of month-end.
Data from January 2019 to March 2021. Past characteristics of asset-class returns are not necessarily indicative of
future results. There is no assurance that the composite will be able to achieve its objectives. Source: AlphaSimplex.
Page 3April 2021
Given how strong the fixed income trends have been over the past ten years, particularly long
bond trends, this smaller risk allocation has been a somewhat infrequent occurrence. To
demonstrate this, Figure 4 plots the risk allocation for fixed income since 2010. Note that in
January 2021, the risk allocation in fixed income was 7%, which is in the bottom 3–5% of all
months over the last ten years. These last few months have made us pause. With signals
turning to net short and the relative risk allocation at all-time lows, could we finally see the
demise of the 40-year long bond trend?
Risk Allocation to Fixed Income (since 2010)
20
18
16
Number of Months
14
12
10
8 January
6
2021
4
2
0
Figure 4: Histogram based on the asset-class risk budget of a representative account of the AlphaSimplex Managed
Futures Strategy. The orange column includes January 2021. These risk budget estimates reflect positions in
derivatives (such as futures and forward contracts), but exclude cash investments in money market instruments.
Percent of risk budget estimates are based on trailing 1-month volatilities (standard deviation) of daily instrument
returns as of month-end. Data from August 2010 to March 2021. Past characteristics of asset-class returns are not
necessarily indicative of future results. There is no assurance that the composite will be able to achieve its objectives.
Source: AlphaSimplex.
A Powerful Reflation Trade
In the wake of faltering bonds in 2020, a new powerful cross-asset trend emerged: the
reflation trade. Reflation is defined as the expansion of an economy’s output by either
monetary or fiscal policy. In practical terms, this has meant the act of pumping money into
the system has generally sent prices roaring upwards. In simple terms, we have seen equity
markets come back to surpass pre-spending and pre-COVID-19 levels; commodity prices
experienced serious momentum and continued spending put pressure on the U.S. dollar,
weakening its relative purchasing power. It is not necessarily the act of reflation that has
sounded some alarms, but the speed of reflation that has caused us to consider what this
may mean. To demonstrate this point, Figure 5 plots the price of corn futures from 2020 to
present. This graph alone could make someone pause. If you needed to buy corn during the
“reflation” period, this was certainly disconcerting, but from a trend-following perspective,
that period offered spectacular and highly profitable opportunities.
Page 4April 2021
Corn Prices (2020–Present)
600
COVID-19
Crisis
550
Reflation
500
450
400
350
300
Figure 5: Corn prices from January 2020 to March 2021. Source: Bloomberg.
Taking a closer look at reflation, we consider a simple reflation factor: long equities, long
commodities, and short the U.S. dollar. Figure 6 plots the return of the reflation factor both
with and without equity market returns. We note that without equity returns the reflation
factor is even more pronounced across different time periods. In the post-COVID-19 crisis
recovery, the factor has been particularly strong.
Reflation Index Growth (2019–Present)
$1.30
Pre COVID-19 Crisis Post COVID-19 Crisis Recovery
COVID-19
$1.25
Crisis
$1.20
$1.15
$1.10
$1.05
$1.00
$0.95
$0.90
$0.85
$0.80
Reflation Index With Equities Reflation Index Without Equities
Figure 6: This chart shows two versions of a “Reflation Index,” a sample index that can be used to demonstrate the
growth of $1 invested in a selection of assets that are likely to be affected by reflation. Reflation Index With Equities
is equally weighted between long S&P 500, short U.S. dollar, and long commodities. Reflation Index Without Equities
is equally weighted between short U.S. dollar and long commodities. The commodities positions are an equally
weighted basket of industrial metals and agricultural commodities. Both indices are risk targeted to 10%. Data is
from January 2019 to March 2021. Past performance is not necessarily indicative of future results. Source:
AlphaSimplex, Bloomberg.
Page 5April 2021
A Shift From Monetary To Fiscal Policy
Post-2008, markets have turned to the Fed and other central banks to ease their pain with
quantitative easing. Rates simply continued their march down to zero or below. In this
environment, the negative correlation between bonds and stocks has been a portfolio
diversifier. When equities were down, bonds were there to cushion the fall. After the COVID-
19 crisis, markets have begun to sing a different tune. From a trend perspective, this means
that bonds seem to exhibit less negative correlation to equities and seem to cushion the
downside in equities less than in previous years. To demonstrate this, Figure 7 plots the
downside capture ratio for classic defensive assets: bonds (the U.S. 10-Year Note), gold, and
safe-haven currencies (the Japanese yen and Swiss franc). This graph shows downside
capture for three distinct periods: pre-COVID-19, the COVID-19 crisis, and post-COVID-19,
with the periods defined by the peak-to-trough drawdown for the S&P 500 during the COVID-
19 crisis. Downside capture gives a measure of how much cushion you may have from an
asset when the equity market is down. 1
Equity Downside Capture
(Pre-COVID-19 Crisis, COVID-19 Crisis, Post-COVID-19 Crisis)
40%
Reduced Downside Capture
30% for Defensive Assets Post
COVID-19 Crisis
20%
10%
0%
-10%
-20%
-30%
Pre-COVID-19 COVID-19 Crisis Post-COVID-19
(January 1, 2019 – February 19, 2020) (February 20, 2020 – March 23, 2020) (March 24, 2020 – March 31, 2021)
Bond Gold JPY Futures CHF Futures
Figure 7: Downside capture for defensive assets: U.S. 10-Year Bonds, gold, and safe haven currencies (the Japanese
yen and Swiss franc) during three periods: pre-COVID-19, the COVID-19 crisis, and the post-COVID-19 crisis period.
Past performance is not necessarily indicative of future results. Source: Bloomberg, AlphaSimplex.
1
We calculate the Down Side Ratio (DSR) capture as a ratio of mean bond returns on the n-worst stock return days
compared to the mean stock return on those days. Keeping things simple, we do it for the worst ten days for pre-
COVID-19 period (January 1, 2019 – February 19, 2020), the COVID-19 crisis period (February 20, 2020 – March
23, 2020), and post-COVID-19 period (March 24, 2020 – March 31, 2021). Note that ten worst days for stocks are
typically expected to be negative by design. However, the bond returns on those days can be either positive or
negative. For a simple definition see also: https://www.investopedia.com/terms/d/down-market-capture-ratio.asp.
Page 6April 2021
The Great Fiscal Experiment
After the Great Financial Crisis in 2008, there was a period of monetary policy and quantitative
easing, with monetary policy in focus for market prices. Central banks had two key tools:
setting the level of benchmark rates (such as the Fed Funds rate) and purchasing plans meant
to boost market prices by providing demand. From a monetary policy perspective, rates began
to creep down to lower and lower levels, with the entire German yield curve going negative
in the summer of 2019. When the COVID-19 crisis hit, rates were at all-time lows with little
room to move. At this point, the world turned to fiscal policy in hopes that stimulus would
alleviate the potential value destruction created by a global pandemic. In simple terms,
pumping tons of capital into the system would keep us from going into a recession and might
eventually slow value destruction and unemployment and support the economy. To
demonstrate this, Figure 8 plots the total government expenditures since 1960. Unfortunately,
it looks a bit like the price of corn in 2020. Note that this plot ends in Q4 2020 and there is
much more stimulus to come, hence the orange arrow for 2021.
U.S. Government Total Expenditures (1960–2020)
$12,000
2021
$10,000
$8,000
$6,000
$4,000
$2,000
$0
Apr-1965
Apr-1972
Apr-1979
Apr-1986
Apr-1993
Apr-2000
Apr-2007
Apr-2014
Oct-1961
Oct-1968
Oct-1975
Oct-1982
Oct-1989
Oct-1996
Oct-2003
Oct-2010
Oct-2017
Jan-1960
Jul-1963
Jan-1967
Jul-1970
Jan-1974
Jul-1977
Jan-1981
Jul-1984
Jan-1988
Jul-1991
Jan-1995
Jul-1998
Jan-2002
Jul-2005
Jan-2009
Jul-2012
Jan-2016
Jul-2019
Figure 8: Plot of fiscal spending in the United States. Source: U.S. Bureau of Economic Analysis, Government total
expenditures [W068RCQ027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis. Amount given in USD
billions. Data is from January 1960 to December 31, 2020.
As trend-following managers, we focus on where the market is going, not why it is going
there. Yet given the graphs in this paper, it is hard for anyone not to wonder why and what
will happen next in this Great Fiscal Experiment? To begin to understand, we take a detour
into a controversial way to think about value, money, and the way markets and economies
may work: Modern Monetary Theory. This approach certainly wasn’t taught in our M.B.A. or
Ph.D. programs, but it is gaining popularity and may lead us to some answers.
Page 7April 2021
Modern Monetary Theory
Money is defined as something that has value and is accepted as payment for goods and
services. When a government can issue its own money, often termed a “fiat currency,” it
creates a monopoly on that currency. According to Modern Monetary Theory (MMT), a
controversial economic theory, this in turn allows a government the power to manage the
supply, the power to create new money, and the power to use more money to pay off debts
in its own currency. Figure 8 certainly makes us think of the second point. In traditional
economics, printing money is generally viewed as dangerous, as it may lead to inflation and
adverse consequences. Proponents of MMT suggest that money creation is just another tool
that doesn’t necessarily lead to adverse economic situations. In fact, money printing has been
going on significantly since the Great Financial Crisis but so far has not led to inflation. 2
Still, there are several key concerns. The biggest one is inflation. If money creation gets out
of hand and money gets pumped into goods we need to purchase, the prices for goods may
skyrocket. Inflation means the assets we currently own and our own cash would be worth less
in terms of purchasing power, which is also concerning. In addition, given that countries are
not islands, if a government decides to create excessive money it may see massive pressure
on its currency. In today’s world with massive fiscal stimulus this could mean there are two
key risks:
1. Inflation
2. Bond rates could either stay at zero or experience inflationary pressure
To many traditional economists, this view sounds like a game of monopoly where you get to
do whatever you want with the cash and even add more to your pocket when it suits you. You
would certainly win the game, but at what cost? Even more complex, if there are many
different bankers, each with their own money, all playing this game of monopoly with each
other. How would that turn out? It certainly sounds complicated. One might even wonder how
long before someone gets up and throws the board at another player.
Thankfully for us, we are trend-followers, not economists. The current trends are providing a
few signals that these risks may not be unfounded. Unlike most investors, we are not overly
concerned. If inflation were to occur, commodities and other assets would likely experience
big trends. In fact, using longer-term historical data, Greyserman and Kaminski (2014)
showed that trends were stronger in inflationary and rising inflation environments. Commodity
markets in particular tend to demonstrate bigger price moves with inflation. Finally, if bonds
are no longer a defensive trade, we could see bonds providing little-to-no return with low-to-
zero rates; or if inflation hits, we could see longer-term bonds devalue, causing serious
concerns for investors who hold long-term bonds. From a trend-following perspective, if bonds
2
Edwards and Mohamed 2020.
Page 8April 2021
do not move, their trends will be weaker; if bonds devalue with inflation risk, short-bond
trends may be an opportunity going forward.
To demonstrate this, we consider a historical perspective. Figure 9 plots inflation as defined
by the changes in the CPI index since 1970. The horizontal lines divide different inflationary
regimes: low (4%). It has been almost four decades
with very low inflation.
Inflation (1970–Present)
16%
14%
12%
High
Inflation estimates
10%
8%
6%
Moderate
4%
2%
0%
-2%
Low
-4%
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Figure 9: Inflation calculated as the change in the CPI index from January 1970 to March 2021. Past performance is
not necessarily indicative of future results. Source: FRED.
2020 has sounded alarms for some investors as forward estimates are starting to tick higher.
To demonstrate this, Figure 10 plots inflation estimates using changes in the CPI and a real-
time daily estimate from State Street. 3 The real-time estimates for inflation are moving into
moderate territory, with estimates ranging from 1.6% (based on CPI) to 3.4% (based on
State Street’s PriceStats).
3
State Street PriceStats provides high-frequency measures of inflation and exchange rates drawn from prices on
millions of prices sold from online retail.
Page 9April 2021
Inflation Estimates (2019–Present)
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
Real time inflation estimates (State Street PriceStats) Inflation estimates from CPI change (FRED)
Figure 10: Inflation estimates for January 2019 to March 2021. Past performance is not necessarily indicative of
future results. Source: Bloomberg, FRED, State Street PriceStats.
If inflation were to come back, even at moderate levels, what would this entail? Certainly
inflation would affect cash flows and real assets such as bonds and commodities. To consider
the impact of inflation, Figure 11 plots the average return for bonds and commodities over
different inflationary regimes (as described above) using the U.S. 10-Year bond and the GSCI
Index as proxies for investments in bonds and commodities. In Figure 11, it is clear that
commodities seem to provide larger returns during higher-inflation periods, whereas bonds
struggle more with higher inflation. This is because bonds face two opposing forces: the
positive impact of a weaker dollar versus the headwinds of rising rates. Either way, consistent
with Greyserman and Kaminski (2014), higher inflation tends to mean more trends, which
can provide opportunities for trend-following strategies.
Bond and Commodity Returns Across Different
Inflationary Regimes (1970–present)
1.2%
1.0%
0.8%
Returns (%)
0.6%
0.4%
0.2%
0.0%
-0.2%
-0.4%
Low Inflation Moderate Inflation High Inflation
(4%)
Average GSCI Index Returns Average Bond Returns
Figure 11: Average bond and commodity returns using the GSCI Index as a proxy for commodity returns and a price
series from the U.S. 10-Year Bond for estimated bond returns. Data from January 1970 to March 2021. Past
performance is not necessarily indicative of future results. Source: FRED, Bloomberg, AlphaSimplex.
Page 10April 2021
Summary
Over the last few months post-COVID-19, there have been substantial trends in global
markets. Recent themes have put into question the future of what has been an almost 40-
year bond bull market. In the wake of increased fiscal stimulus, markets have shifted focus
from monetary policy to fiscal policy, giving way to what has been deemed the reflation trade.
Recent selloffs in the bond market, particularly in longer-duration bonds, have shown the shift
in utility of bonds as a cushion for equity drawdowns. As trend-followers, we have been
watching these themes unfold, leading to questions that do not yet have answers. Instead,
with the backdrop of MMT, there are certain risks for inflation and the potential for a very
different period for fixed income. Both of these may create new and potentially disruptive
trends for traditional investment portfolios. To the trend-follower, this shift can signal
opportunity instead of challenge, and we are ready.
References
• Chohan, Usman W. 2020. “Modern Monetary Theory (MMT): A General Introduction.” CASS
Working Papers on Economics & National Affairs, Working Paper ID EC017UC.
https://dx.doi.org/10.2139/ssrn.3569416.
• Edwards, Jim and Theron Mohamed. 2020. “MMT: Here’s a plain-English guide to ‘Modern
Monetary Theory’ and why it’s interesting.” Business Insider.
https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3.
• Greyserman, Alex, and Kathryn M. Kaminski. 2014. Trend Following with Managed Futures: The
Search for Crisis Alpha. New York: Wiley Trading.
Page 11April 2021
About the Authors
Kathryn M. Kaminski, Ph.D., CAIA® is the Chief Research Strategist at AlphaSimplex Group. As Chief
Research Strategist, Dr. Kaminski conducts applied research, leads strategic research initiatives, focuses
on portfolio construction and risk management, and engages in product development. She also serves
as a co-portfolio manager for the AlphaSimplex Managed Futures Strategy. Dr. Kaminski’s research and
industry commentary have been published in a wide range of industry publications as well as academic
journals. She is the co-author of the book Trend Following with Managed Futures: The Search for Crisis
Alpha (2014). Dr. Kaminski holds a B.S. in Electrical Engineering and Ph.D. in Operations Research from
MIT.
Saurabh Kelkar, M.F.E., is a Junior Research Scientist at AlphaSimplex Group. As a Junior Research
Scientist, Mr. Kelkar focuses on applied research and supports the portfolio management teams. Mr.
Kelkar earned a B.Tech in Chemical Engineering from the Indian Institute of Technology Bombay, with
a minor in Electrical Engineering and an M.F.E. from University of California, Berkeley.
Contact Information
For more information, please contact:
clientservices@alphasimplex.com
617-475-7100
Disclosures
Past performance is not necessarily indicative of future results. Managed Futures strategies can be
considered alternative investment strategies. Alternative investments involve unique risks that may be
different from those associated with traditional investments, including illiquidity and the potential for
amplified losses or gains. Investors should fully understand the risks associated with any investment
prior to investing. Commodity-related investments, including derivatives, may be affected by a number
of factors including commodity prices, world events, import controls, and economic conditions and
therefore may involve substantial risk of loss.
The illustrations and examples presented in this document were created by AlphaSimplex based on
unaudited internal data and methodologies. Accordingly, while the underlying data were obtained from
sources believed to be reliable, AlphaSimplex provides no assurances as to the accuracy or completeness
of these illustrations and examples. The views and opinions expressed are as of 3/31/2021 and may
change based on market and other conditions. There can be no assurance that developments will
transpire as forecasted and no representation is made that Managed Futures strategies will experience
favorable results in the future. All investments are subject to risk, including risk of loss.
This document has been prepared for informational purposes only and should not be construed as
investment advice. AlphaSimplex is not registered or authorized in all jurisdictions and the strategy
described may not be available to all investors in a jurisdiction. Any provision of investment services by
AlphaSimplex would only be possible if it was in compliance with all applicable laws and regulations,
including, but not limited to, obtaining any required registrations. This material should not be considered
a solicitation to buy or an offer to sell any product or service to any person in any jurisdiction where
such activity would be unlawful.
Publication: April 2021. Copyright © 2021 by AlphaSimplex Group, LLC. All Rights Reserved.
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