Economic Activity and Time Variation in Expected Futures Returns

Abstract: This article studies the link between the predictability of futures returns and the business cycle. Modelling the relationship between the variation through time in expected futures returns and economic activity should give us some insight as to whether the predictable movements in futures returns result from rational variation in the returns required by investors over time. With this in mind, the paper investigates three hypotheses that are consistent with weak-form market efficiency. First, it tests whether the time-varying risk premia identified in futures markets move in tandem. Second, it examines if the information variables predict futures returns because of their ability to proxy for change in the business cycle. Third, it analyses whether the pattern of forecastability in futures markets is consistent with the evidence from the stock and bond markets and with traditional theoretical explanations of the trade-off between risk and expected returns. Three conclusions emerge from this analysis. First, the forecast power of the information variables over futures returns is related to their ability to proxy for economic activity. Second, the pattern of forecastability for metal, stock index, and interest rate futures is consistent with the evidence from the equity market and with extant economic theories. During recessions the expected returns on these futures increase to reflect the riskiness of the business cycle and to induce investors to differ consumption into the future. Third, this evidence does not extend to currency and agricultural commodity futures. For these futures indeed the information variables signal above (lower) average expected returns in periods of economic expansion (recession). This pattern is clearly at odds with the predictions of economic theory. It follows that some further theoretical work is needed to account for what can only be termed so far an ?anomaly?.