Is the Fed a Trend Follower?

OK, granted - we are not suggesting that the U.S. Federal Reserve is a professional Trend Following investor. In fact, we may have deliberately chosen this title to entice you to click on it and read this blog post.

But we did that for a reason. You see, in the current macroeconomic environment, we as Trend Followers have some very important things to say. Things that for a private and/or a professional institutional allocator might be worth considering.

Let’s start with a bit of theory. In the world of statistics, a probability distribution (like the famous bell curve) is characterized by 4 moments – mean, standard deviation, skew, and kurtosis. Kurtosis – the 4th and probably least known moment – is a measure of how tail-heavy a distribution is. There are three types of kurtosis – mesokurtosis, leptokurtosis, and platykurtosis. Before you fall asleep, let’s take a look at the below pictures to illustrate these terms:

Source: Wikipedia

All you need to know about these pictures is that the blue line represents the normal distribution (mesokurtosis), that the red line on the left represents a leptokurtic distribution, and the red line on the right represents a platykurtic distribution.

A very unscientific way to describe a leptokurtic distribution (picture on the left) is to call it a normal distribution with fatter tails and a peak that’s been pulled up. In other words, this is a distribution where most of the time there is little deviation from the centre but when volatility increases, the outcomes are more extreme than what you would expect vs a normal distribution.

Does this “amateur” description of a leptokurtic distribution remind you of anything? Doesn’t it seem very similar to much of the world we have been living since the Global Financial Crisis? A world of tightly held financial markets, underpinned by Quantitative Easing and coordinated Central Bank actions which subdue volatility for most of the time only to be pinched by periods of extreme market moves (especially on the downside)? Yes, most of the post-2008 financial markets world has behaved like a leptokurtic distribution.

Now, let’s take a look at the picture to the right. A platykurtic resembles a normal distribution that has had its peak squashed down, and as a result, there is much higher variation around the centre of the distribution. Now, let’s think about the current economic environment. In a world where Central bank policies are finally diverging from each other (think about the current policy stance of the Fed vs the ECB), what you tend to see is more uncertainty and higher variation around the mean. Put in other words, we are now transitioning into a world, where the return profile of the market shifts from leptokurtic to platykurtic.

Why is this relevant for Trend Followers and investors into the strategy?

It is relevant because Trend Following tends to perform well in platykurtic market regimes like the one we are entering right now. Mark Rzepczynski was a guest in this week’s episode of the Systematic Investor Podcast Series and, among many other things, explained why Trend Following is poised to perform well in the current platykurtic macroeconomic environment.

We warmly invite you to tune into this week`s episode with Mark and as usual, we promise your time will be well spent!