In this research note, we provide a simple framework that illustrates why in a higher cash rate environment, trend- following CTAs become more – not less – attractive relative to bonds.

Our results are based on a basic three-asset portfolio, consisting of US equities, US government bonds, and a proxy index for diversified trend-following CTA strategies. We evaluate the historical excess returns of the three assets over the last 35 years, conditional on the level of the US risk- free rate, the 3-month US Treasury bill rate. We do not find a statistically significant difference in the future expected excess returns for these assets conditioned on the US cash rate. However, we do observe a statistically significant difference between low and high cash rate environments in a variable that is crucial to portfolio construction: the correlation between US equities and US government bonds. Specifically, we show that when the US cash rate has historically been above 3%, the average equity-bond correlation has been significantly less negative than when the cash rate has been below 3%.

These findings have important implications for adjusting portfolio allocations in response to a higher level of the cash rate. Using a set of simplified but conservative assumptions, we show that while a 55/35/10 equity/bond/trend- following portfolio may be more optimal than the traditional 60/40 equity/bond allocation in a low cash rate environment, the optimal allocation shifts to a 55/25/20 portfolio with a higher trend-following CTA weight when the cash rate is high. The increased optimal allocation to trend-following in a high cash rate environment is mainly driven by the change in the equity/bond correlation. Specifically, we show that under the same simplified assumptions, a 10% increase in US equity-bond correlation is expected to raise the optimal trend-following allocation by 2.5%, offset by an equal reduction in bond allocation. This is because, while the diversification benefits of bonds diminish in a higher cash rate environment, trend-following CTAs maintain an average near-zero correlation to both equities and bonds, regardless of the cash rate level. As a result, the optimal allocation to trend-following increases in a high cash rate environment, primarily by reducing the bond allocation, while the allocation to equities remains largely unchanged.

In summary, our analysis demonstrates that trend-following CTAs may offer key diversification benefits to equity/bond portfolios across various market conditions, with these advantages becoming even more pronounced when cash rates are higher than average. Therefore, incorporating a trend-following allocation into an equity/bond portfolio can improve its risk-return profile by making it more resilient to the key risk of shifting equity/bond correlations.