An Unholy Alliance Between Commodities And Bonds

By: Greg Silberman | Fri, Oct 12, 2007
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The strong positive correlation between Bonds and Commodities is creating an unholy alliance and confusing investors.

Strange how markets work!

Just when we thought we had it all figured out, just when we became convinced that inflation would win the day, those damn Treasury Bills just refused to confirm our hypothesis.

There is a somewhat strange and almost unholy alliance developing between Bonds and Commodities.


Chart 1 - 10Yr Treasury Price vs. Crude Oil (green)

The theory is that rising commodity prices (we have used Crude Oil in our example) is price inflationary. That is, when raw material prices rise, the general price level rises along with it.

The Fixed Income markets are supposed to be hyper-sensitive to price inflation. Bonds are supposed sniff out price inflation and interest rates should rise rapidly as they discount the effect of an increase in price inflation.

Therefore, a well worn economic rule is that commodities should move inversely to Bonds.

Not so per the above chart. During certain periods - November 2006 to February 2007 and June 2007 to September 2007 - both Oil and Bonds moved together. Oil climbing on inflationary fears and Bonds from a flight to safety ala credit crunch.

Whereas we can only speculate as to why or how long these two markets move together (perhaps debt monetisation / a continued flight to safety from the real estate slump) we are fairly certain that in the long-term they will decouple and go their own separate ways.


Chart 2 - Long-term chart shows Bonds and Oil negatively correlated

Our guess is that with the propensity and willingness of the Fed to reduce rates further, a long Oil short Treasury position will win out in the end.

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Author: Greg Silberman

Greg Silberman CA(SA), CFA
www.goldandoilstocks.com

Greg Silberman

Profession: Research Analyst and Newsletter Editor
Company: Ritterband Investment Management LLC

Career Brief: Greg qualified as the youngest Chartered Accountant and Chartered Financial Analyst (CFA) in South Africa in 1998 at 25 years old. After completing his traineeship with Grant Thornton he moved to London where he worked for JP Morgan Chase in their Fixed Income Swaps Division. Sick of the grey skies and cold weather Greg relocated to Atlanta, Georgia where he spent the next 4 years freelancing as a management consultant. His targeted clients were fast growing mid size US based companies and he worked across many industries including credit cards, health insurance and energy trading. Greg has recently returned from Sydney Australia where he spent the last 2½ years working in Equity Derivative Structuring for Perpetual investments a major Australian Asset Management Company.

Greg has a passion for the markets and has been writing Greg's market newsletter for 2-years. A newsletter focused on metal and energy stocks and recently non-resource small caps listed in the US and Internationally.

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

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