Risk comes from not knowing what you are doing Warren Buffett (1930 -)
Having looked briefly at the four capital markets on an individual basis, I now want to look at some of the bilateral relationships between these markets. And in this chapter I would like to focus on the relationship between commodities and bonds which is perhaps the least
understood, but is one of the most important of all these cross market relationships.
The relationship between bonds and commodities is one that most traders ignore, either because they are so focused on their own sector of the market, or simply because they do not understand it, or even realise there is one!
However, I must stress before we go on any further with this chapter that the relationship
between bonds and commodities is probably the most complex to understand. But please don’t worry because it will all become clear, the further you read. Indeed, one of the reasons this chapter may seem complicated is because the bond/commodity relationship is multi-faceted, and so can be looked at from a number of different angles.
In addition, it is not a straightforward linear relationship, and you also need to have an understanding of the factors which affect this linkage, which are also multi-faceted and constantly shifting.
Sometimes it can seem like trying to pick up a jelly. And perhaps the best way to try and visualise this relationship is to imagine it as a simple compass, with bonds at the West, commodities at the East, inflation at the North and the US dollar in the South.
What this then describes is the interplay between these four points with the compass needle moving according to where we are in the economic cycle.
Having already touched on the economic cycle in the chapter on equities, it is a topic we will be looking at in detail in a later section of the book when dealing with fundamentals. However, for the purposes of this chapter, I want to focus on the primary catalysts of economic activity, which could be inflation, deflation or even stagflation.
Again, I will explain all these terms in detail in due course. For the time being I am going to concentrate on inflation, which, put simply, is the overall, general upward price movement of goods and services in an economy - in other words things become more expensive and the value of money is eroded, in real terms.
However, just to complicate matters, inflation is not necessarily a bad thing, it only becomes
bad when it reaches a tipping point - and it gets out of control. The other issue with inflation is that there are various types which will have very different effects on the bond and commodity relationship. So let me just clarify this and why as, forex traders, this is so important to
understand.
It is actually very easy when you accept that whenever a government is faced by inflation it has only one, very crude and blunt weapon with which to manage its effect on the economy. In other words, interest rates. This is the weapon used by all central banks to either slow down or speed up their economies. This in turn partially explains why economies, in general, move in a cyclical nature, with economic growth and expansion, subsequently followed by economic contraction and finally recession.
Unlike many other financial markets, there are no direct economic charts to tell us where we are in an economic cycle, and the likelihood of inflation or deflation, which in turn could signal any likely changes in interest rates. However, in analysing the relationship between bonds and commodities some clues are revealed, as both are key indicators of inflation and hence of future changes in interest rates which are so important to us as forex traders.
Bonds and commodities tell us a great deal about inflation and deflation, as they are the principle markets used by central banks to gauge economic growth and on which interest rate decisions are therefore based. It is also the relationship where global economic demand meets the cost of money, and the currency of first reserve, i.e., the US dollar.
As forex traders the principle reason we look at the relationship between bonds and commodities is their direct link to inflation, and inflation expectations in the future.
Therefore, let me start at the end, and then I’ll explain how we arrive at this conclusion, and it is simply this. Whenever we see commodity prices and bond yields rising in tandem, then we can expect to see inflation in the economy and a consequent change in interest rates as a result.
This is the start of our inflation expectation, from where the economic cycle begins. To try to explain this relationship I’ll start with the commodities side of the equation, but first we have to remember three things about commodities.
First, all commodities are not equal.
Second, commodities are an asset class just like a stock or bond.
Third, commodity prices rise for several different reasons and not necessarily because of inflation expectations.
Starting with the first statement that all commodities are not equal. By this I mean we have to be careful when simply saying that commodity prices are rising and therefore we should expect inflation.
Gold, for example, is a commodity which is neither consumed nor used in industry, to any great
extent, and therefore could never be considered to be representative of the commodity sector.
Yet gold is also the ultimate safe haven when investors are looking for a secure asset in uncertain times. That said, gold is also a hedge against inflation.
If the price of gold is rising, then one factor could be that the flow of money is into gold as a hedge against inflation. Therefore, in its own way gold is an indicator of potential inflation.
However, it could also be attracting money flow for safe haven reasons.
Silver too could be considered in much the same way, and even though silver is classed as an industrial metal, it is increasingly seen as a safe haven and a low cost alternative to gold.
If you recall when we first began to look at commodities we looked at the three main sectors of agriculture, metals and energy. Of these, the first and perhaps easiest to understand in terms of inflation is the agriculture sector, which includes all the basic commodities grown or reared by farmers around the world, such as cereals, grains, livestock, timber and cotton.
We don’t need to be an economist to realise that if the price of corn and wheat is rising, then basic everyday foods such as bread will also rise in price along with meat prices, since cattle feed uses both wheat and corn.
These price rises will ultimately be reflected in the economic figures for inflation, which are generally based on a standard basket of products and everyday consumables. This is why rising commodity prices are considered to be a leading indicator of inflation.
However, these prices do not usually filter through the system for at least six to nine months, and sometimes take even longer, which is an important point. These effects of inflation can take time. They do not happen immediately, and may even take between one to two years before the effects are fully reflected in any fundamental data.
Therefore, we cannot jump to the conclusion that rising commodity prices equals rising inflation with an imminent rise in interest rates. Not least because commodities have to be bought and paid for, and then converted into other goods before being bought and sold, before any inflation figures appear in the economic data.
Let’s take corn as an example and consider the various factors that could influence the price, and whether we should view any price increase as a signal of future inflation, or whether the increase in price is merely a temporary factor.
Commodity prices are generally driven by supply and demand, and if a commodity is in
demand, then prices are likely to rise. However commodity prices could also be rising due to a lack of supply, due to growing conditions and, in the case of corn this could typically arise from weather problems such as drought or flood.
This often leads to trade embargoes with supply restrictions being imposed by governments.
For example, large grain producers such as Russia will always ensure that home consumption takes priority over export markets.
Finally we have the US dollar in which virtually all commodities are priced. If the US dollar is weakening then commodity prices in general will rise, and conversely if the US dollar is strengthening, then commodity prices are likely to fall.
Let us examine these factors in more detail.
If prices are rising due to demand then this will eventually give rise to inflation, as these higher prices feed through into the system.
If prices are rising due to a supply problem, then this is only likely to be a short term issue, and therefore unlikely to cause inflationary pressure in the system.
If the US dollar is weakening, this too will cause commodity prices to rise making them more expensive and therefore driving inflation into the economic system.
The question is how do we differentiate between these three scenarios and decide whether the price of a commodity is rising due to demand, supply or weakness in the US dollar?
The last of these is easy, as we simply have to look at a chart for the US dollar to show us the trend and whether it is weak or strong. And, as a very general rule, as the dollar falls then commodity prices rise and visa versa, although not always.
The tricky part is deciding whether a rise in a commodity price has been driven by supply or demand, and in order to check this, we have to turn to the futures market and consider whether the price is in contango or backwardation.