Last Updated on June 19, 2022 by Quantified Trading
Bond trading strategies are difficult to find. Bonds are susceptible to erratic macro numbers and we believe bonds are harder to trade than stocks. Can the Japanese stock market predict the trend in US Treasury bonds?
In this article, we look at how the Japanese stock market has predicted the trend in US Treasury bonds pretty well. Does it work? Yes, it seems to work pretty well, but this is not a strategy we trade or recommend.
We have previously written a couple of articles about trend-following strategies in the S&P 500 and gold:
- Trend following strategy in gold
- A simple trend following system in the S&P 500 (Meb Faber)
- Conclusions about trend following systems in the S&P 500
What is trend following?
A back of an envelope algorithm is often good enough to compete with an optimal formula, and certainly good enough to outdo expert judgment.
The statement above was made by the famous trend-following guru Micheal Covel, author of several books.
We believe what Covel says captures the essence of trend-following: trend-following has testable and quantifiable rules that are easy to grasp and understand. Even your grandma can understand the basic principles behind trend-following.
Trend-followers don’t aim to time that market but reckon once in a while that they will capture a big move either on the long side or on the short side.
Trend following drawbacks:
However, the main problem with trend-following, though, is the profit distributions. It produces many small losers while you get the rare big winner that offsets all the losers. Most trend-following strategies have a low win ratio. Opposite, mean reversion strategies, have a higher win ratio but are often negatively skewed.
Most humans are mentally equipped to handle many winners, not to handle many losers, and we make behavioral mistakes. Hence, trend-following is not easy to follow, and perhaps that’s exactly why it seems to continue working.
Trend following strategy in Treasury bonds:
Here is one peculiar twist, which we first found on Jay Kaeppel’s webpage. We changed the criteria slightly and tested this:
When Japanese stocks are above their 150 day moving average, go long TLT (US long-term Treasuries). When the average is below the 150-day average, stay out.
In this article, we use the ETF with ticker code EWJ as a proxy for Japanese stocks.
Why would we use Japanese stocks to define the trend in US Treasury bonds?
We have no idea, and would certainly not recommend trading something like this.
No matter what, the performance has been pretty good over the last 20 years (logarithmic chart):
CAGR is 6.5%, the same as buy and hold, and max drawdown is 21% vs. buy and hold’s 27%. The strategy is invested 37% of the time. Unlike many other trend-following strategies, the win-ratio is high at 63%. Moreover, the average winner is 3% while the average loser is only 1.19%. These numbers result in an expected win of 1.44% per trade which lasts for 22 trading days.
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Ending remarks about our trend following strategy in Treasury bonds:
Can we really use Japanese stocks to predict the trend in US long-term Treasury bonds? Empirically, yes, but we would be reluctant to trust this backtest. We might suspect this is a spurious correlation.