Is Momentum Flow Riding the Interest Rate Rollercoaster?

As we wrote in last week’s Factor Spotlight - and as was highlighted in a recent Bloomberg article - a historic, pandemic-related systematic strategy rebalance is expected to lead to a significant momentum rotation over the coming weeks, which has already begun.

This past Wednesday saw the Fed announce that it will not be instituting rate hikes in the immediate future, giving the economy more runway to continue to grow. Officials greatly adjusted forecasts for GDP growth and unemployment, exhibiting additional confidence in their near-term outlook. Following the announcement, interest rates surged higher with the 10-year treasury yield reaching 175 basis points Thursday morning: its highest level since January, 2020.

Since the stock market hit its trough last March due to the COVID pandemic, the 10-year yield has risen by approximately 120 basis points. About two thirds of that climb has occurred year-to-date. As we continue on the path of rapid economic recovery spurred on by vaccinations and re-openings, many feel the trend of rising rates is likely to continue.

Last week, we discussed the impending momentum rotation as the COVID crash slips outside of the traditional twelve-month window for medium-term momentum calculations. The rotation will be largely driven by systematic strategies that depend heavily on momentum factors. In our analysis, we created portfolios that were long stocks most likely to benefit and were short stocks most likely to be harmed by this shift.

Given the timeliness of the momentum rotation and interest rates, we will introduce the Interest Rate Beta factor from the Wolfe Research QES US Broad (“Wolfe US Broad”) risk model into our analysis. As rates have risen, particularly year-to-date, The Interest Rate Beta factor has seen a spike in performance.

In order to provide deeper insight into how these factors can be managed in conjunction, we will:

• Determine what role Interest Rate Beta plays in the current Momentum Flow portfolios.
• Combine the factors to create a more effective set of stocks to carry through the March rebalancing period and beyond, as the economic recovery continues to heat up.

Methodology

Our approach for this analysis is to build upon last week’s Momentum Flow portfolios by first analyzing the degrees of Interest Rate Beta exposure on both the long and short sides of those portfolios and applying further filtering. The first Momentum Flow portfolio was constructed as a market-neutral form of the Russell 3000 index, re-weighted based on the delta in Medium-Term Momentum exposure from February to March. The second portfolio utilized the same framework but was screened for long names with high HF Crowding exposure and short names with high Short Interest exposure.

The further filtering we will apply this week will eliminate both long and short stocks that do not provide significant Interest Rate Beta exposure. The Interest Rate Beta factor generally measures a stock’s sensitivity to changes in the 10-year treasury yield so stocks with positive exposure will see positive performance contribution when rates are rising and negative contribution as rates fall. For the long side, we will remove any stocks from the portfolios that do not have an Interest Rate Beta exposure greater than 1. On the short side, we will remove any stocks from the portfolios that do not have an Interest Rate Beta exposure less than -1.

Current Interest Rate Beta Exposure of Momentum Flow

‍Here, we are using the Wolfe US Broad model to analyze the current factor exposures. As expected, on aggregate, last week’s Momentum Flow portfolios have a good degree of exposure to Interest Rate Beta already. In the tables below, we see that Interest Rate Beta is the second highest style factor exposure for both Momentum Flow portfolios.

Even though the top-level exposure is positive, we really want to maximize our Interest Rate Beta to capitalize on the rising rate environment which is where our filtering comes into play.

‍Interest Rate Beta Filtered Portfolios

‍When we analyze the results of our filter, we not only see increases in Interest Rate Beta exposure but also increases in Leverage and decreases in Momentum. Oil Beta exposure was another factor that shows very significant jumps which likely hints at the composition of our final portfolios.

Through all of this, the important question we need to answer is: what impact does the Interest Rate Beta filter have on the portfolios’ exposure to our custom Momentum Flow factor? As mentioned in the methodology section, the Momentum Flow factor represents the delta between Medium-Term Momentum exposures from February to March. The factor helps us identify stocks likely to receive inflows and stocks likely to experience outflows during the systematic Momentum rebalance. The exposures are represented in terms of normalized z-scores across the Russell 3000 universe. Will managing our sensitivity to rates in this way support or hinder our ability to navigate the momentum rotation?

‍Momentum Flow Exposure Comparisons

When applying our filter to the original Russell 3000 Momentum Flow portfolio, we increase the Momentum Flow raw factor exposure from 1.24 to 1.75, which means that we have a larger tilt toward stocks that are likely to have heavy inflows and a tilt away from stocks that are likely to have heavy outflows at March month-end. By managing for rising rates, we have improved our positioning for the momentum rotation as well.

Shifting the focus to the portfolio that accounts for crowded stocks on the long side and short interest stocks on the short side, we get an even larger increase in exposure from 2.11 to 2.97. We also see the delta more evenly distributed with both an increase in projected momentum names for March and a decrease in former momentum names from February. We are finding that stocks sensitive to interest rates will help fuel the high Momentum Flow group. Long crowding and short interest could act as additional tailwinds and headwinds for the outperformers and underperformers respectively.

‍Portfolio DNA

‍Now that we have created portfolios aligned with Momentum Flow and Interest Rate Beta in mind, let’s look under the hood at what types of stocks we should be keeping an eye on.

The top industry groups are fairly consistent across the board. What is most notable is that the long exposure to Energy and the short exposure to Pharmaceuticals, Biotech, & Life Sciences are dramatically increased when screening for extreme Interest Rate Beta. These, along with Software & Services, Banks, Retailing, and Consumer Services are all industry groups worth paying attention to when planning for a portfolio rebalance.

‍Turning Analysis into Action

‍Using the above analysis, we have identified an additional factor (Interest Rate Beta) to refine the universe of Momentum Flow stocks that will help us better manage risk and outperform during the impending momentum rotation and continued rise in rates.

US & Global Market Summary

US Market: 03/15/21 - 03/19/21

• It was a disjointed week, with the market ending lower as investor optimism around vaccine rates and reopening was tempered by inflation fears and a troublesome jobless claims print.
• Fed officials announced a continuation of near-zero interest rates through 2023, and that they will continue their asset purchasing program at its current pace. They also upgraded their outlook with a more sanguine view of the economic recovery, and projected an increase in inflation (2.2% this year) to decline to 2% next year.
• Investor concerns over heightened inflation and subsequent rate hikes precipitated a selloff in US bonds, with yields on the 10Y Treasury ending the week at 1.73% (a 14 month high). Tech and high-growth equities also saw weakness, ostensibly due to these same concerns.
• On Thursday, the Labor Department reported an increase in the number of Americans seeking unemployment benefits, up to 770,000 from 725,000 last week, indicating continued layoffs even as the economy is recovering.

‍Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Size saw the week’s biggest jump on a normalized basis, moving up 0.26 standard deviations away from the mean.
• Value didn’t top this leaderboard for the first time in over a month, although it continued its ascent and now sits at +2.01 SD above the mean, earning an Extremely Overbought label.
• Volatility saw a slight upwards move as it continues to bounce back from a recent bottom of -1.82 SD below the mean on 3/9.
• The pain in Growth continued, albeit at a lesser pace. It’s now -2.44 standard deviations below the mean, and judging by the YTD chart, appears to be leveling off.

• Momentum, discussed earlier, fell by 0.13 standard deviations and is approaching Oversold territory at -0.82 SD below the mean.
• US Total Risk (using the Russell 3000 as proxy) increased by 10 basis points.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Earnings Yield continued its steep climb with a half standard deviation move, entering and ascending Extremely Overbought space at +2.33 SD above the mean.
• Value appears to have peaked at +1.37 SD above the mean on 3/16, and ended the week on a downtrend, while still retaining its Overbought designation.
• Global Momentum continued to fall, and is now at -1.26 SD below the mean.
• Growth was again the biggest loser, although the bleeding has slowed as it now sits deep in Extremely Oversold territory at -2.36 SD below the mean.
• Global Risk (using the ACWI as proxy) climbed by 11bps.

Regards,
Kevin