Commodity Prices and Bonds

Of all the intermarket relationships explored in this book, the link between commodity markets and the Treasury bond market is the most important. The commodity-bond link is the fulcrum on which the other relationships are built. It is this inverse relationship between the commodity markets (represented by the Commodity Research Bureau Futures Price Index) and Treasury bond prices that provides the breakthrough linking commodity markets and the financial sector.

Why is this so important? If a strong link can be established between the commodity sector and the bond sector, then a link can also be established between the commodity markets and the stock market because the latter is influenced to a large extent by bond prices. Bond and stock prices are both influenced by the dollar. However, the dollar's impact on bonds and stocks comes through the commodity sector. Movements in the dollar influence commodity prices. Commodity prices influence bonds, which then influence stocks. The key relationship that binds all four sectors together is the link between bonds and commodities. To understand why this is the case brings us to the critical question of inflation.

THE KEY IS INFLATION

The reason commodity prices are so important is because of their role as a leading indicator of inflation. In Chapter 7, I'll show how commodity markets lead other popular inflation gauges such as the Consumer Price Index (CPI) and the Producer Price Index (PPI) by several months. We'll content ourselves here with the general statement that rising commodity prices are inflationary, while falling commodity prices are non-inflationary. Periods of inflation are also characterized by rising interest rates, while noninflationary periods experience falling interest rates. During the 1970s soaring commodity markets led to double-digit inflation and interest rate yields in excess of 20 percent. The commodity markets peaked out in 1980 and declined for six years, ushering in a period of disinflation and falling interest rates.

The major premise of this chapter is that commodity markets trend in the same direction as Treasury bond yields and in the opposite direction of bond prices. Since the early 1970s every major turning point in long-term interest rates has been accompanied by or preceded by a major turn in the commodity markets in the same direction. Figure 3.1 shows that the CRB Index and interest rates rose simultaneously

FIGURE 3.1
A DEMONSTRATION OF THE POSITIVE CORRELATION BETWEEN THE CRB INDEX AND 10-YEAR TREASURY YIELDS FROM 1973 THROUGH 1987. (SOURCE- CRB INDEX WHITE PAPER: AN INVESTIGATION INTO NON-TRADITIONAL TRADING APPLICATIONS FOR CRB INDEX FUTURES, PREPARED BY POWERS RESEARCH, INC., 30 MONTGOMERY STREET, JERSEY CITY, NJ 07302, MARCH 1988.)

during the early 1970s, trended sideways together from 1974 to 1977, and then rose dramatically into 1980. In late 1980 commodity prices began to drop sharply. Bond yields topped out a year later in 1981. Commodities and bond yields dropped together to mid-1986 when both measures troughed out together.

For those readers who are unfamiliar with Treasury bond pricing, it's important to recognize that bond prices and bond yields move in opposite directions. When Treasury bond yields are rising (during a period of rising inflation like the 1970s), bond prices fall. When bond yields are falling (during a period of disinflation like the early 1980s), bond prices are rising. This is how the inverse relationship between bond prices and commodity prices is established. If it can be shown that interest rate yields and commodity prices trend in the same direction, and if it is understood that bond yields and bond prices move in opposite directions, then it follows that bond prices and commodity prices trend in opposite directions.

ECONOMIC BACKGROUND

It isn't necessary to understand why these economic relationships exist All that is necessary is the demonstration that they do exist and the application of that knowledge m trading decisions. The purpose in this and succeeding chapters is to demonstrate that these relationships do exist and can be used to advantage in market analysis. However, it is comforting to know that there are economic explanations as to why commodities ana interest rates move in the same direction.

During a period of economic expansion, demand for raw materials increases along with the demand for money to fuel the economic expansion. As a result prices of commodities rise along with the price of money (interest rates). A period of rising commodity prices arouses fears of inflation which prompts monetary authorities to raise interest rates to combat that inflation. Eventually, the rise in interest rates chokes off the economic expansion which leads to the inevitable economic slowdown and recession. During the recession demand for raw materials and money decreases, resulting in lower commodity prices and interest rates. Although it's not the mam concern in this chapter, it should also be obvious that activity in the bond and commodity markets can tell a lot about which way the economy is heading.