Momentum strong indicator in daily returns

On the side have been working with someone who is looking for long term strategies in the fixed income space. My strategies focus on intra-day trading primarily, but have found the start of a number of very attractive longer term (low frequency) strategies.

In particular, we are building a multi-factor model to predict market movements for Canadian bonds. Alternatively, we are also looking at cointegration models that would be implemented as long/short baskets of securities.

Sometimes the simplest ideas work best. I decided to look at a function of momentum over a period as a predictor of return over the following period. Did not expect to have such strong results. Here is the average return predicted by momentums at various standard deviations from parity:

An alternate graph of this showing standard deviation bands for returns against momentum levels:

There is certainly more work to be done to understand maximum drawdown and optimal money management.

Next Steps
Beyond momentum, we are also looking at building a continuous economic index (much like the Aruoba-Diebold-Scotto Business Conditions Index). This provides a continuous forecast of economic variables based on a stochastic state space model. Will discuss further in the next post.