What Makes Commodities Tick?

commodity stocksThe past few months have given investors a crash course in what makes commodities tick. Your PROFIT CONFIDENTIAL editors have discussed quite a collection of factors that drive commodity prices, such as currencies, emerging markets, economic output, supply and demand imbalances…even weather was mentioned as swinging a few punches.

But I don’t think we have discussed bonds or, more precisely government bonds, in the context of gauging commodity prices. Actually, until recently, commodity prices and government bonds did not have an especially correlated relationship, either converging or diverging. As our world is rapidly changing, it seems certain new relationships have been forged, such as the inversely correlated relationship between commodity prices and government bond yields.

Now, this inversely correlated relationship is anything but logical or historically substantiated. Firstly, the traditional school of economics does not see commodity prices and government bond yields as tightly correlated at all. However, if there were any relationship between the two, typically it would be a positively correlated one.

How can something so essentially illogical be happening? Apparently, the blame lies with the U.S. dollar. Granted, where we are in the economic cycle also plays a role, but to the extent of reinforcing the positively correlated relationship between commodities and government bond yields, not the other way around. This time around, it is the greenback that is fuelling the inverse correlation between the two.

It seems that whatever happens with the dollar, investors are reading its “exploits” into nearly every other asset class. For example, the dollar and the 10-year U.S. Treasury yield have been dancing a similar dance to a similar song. When the Federal Reserve first speculated and then openly came out with the second round of quantitative easing, the intention of which was to keep U.S. interest rates depressed, this created an exodus from both the bonds and the U.S. dollar. As the greenback kept declining, assets priced in the U.S. dollars surged, trying to make up the difference.

But, in the past few trading session, the new bond-commodity inverse correlation has been established, and it is holding, apparently. Analysts are describing the surging government bond yields and downward trending commodity prices as the preview of QE2 unwinding itself in the financial systems. It seems that bond traders have jumped the gun and overpriced the Fed’s quantitative easing into the bond market. In turn, the U.S. dollar seems to be reversing their bets, as the market tries to stabilize interest rates.

There are plenty of signals to read from government bond yields when it comes to commodities. Their relationship with commodity prices is no longer a distant one or necessarily a positively correlated one. There are plenty of factors that could drive bond yields upward, from QE to economic recovery to a higher price environment. If they head higher, they could take the greenback for a ride. If this newly forged inverse relationship between commodities and bonds holds and if the bond yields head up higher, we could see more downward pressures on commodity prices and vice versa. In other words, it might pay to watch the direction of government bond yields if you are an active commodity investor.