The CRB and Long Rates
Adam Hamilton March 26, 2004 2944 Words
Following a brutal two-decade bear market, today is once again a wonderful time to be a commodities investor or speculator. The venerable CRB Commodities Index is trading near 23-year highs and even CNBC manages to find a little time to discuss commodities these days. Will wonders never cease?
Since it has been so long since the last major commodities bull, the full implications of this event for general equity and bond investors are not yet widely considered this time around. As history has shown however, a secular commodities bull often exerts great influence on the prices of both stocks and bonds.
This influence is not direct, but indirect via the price of money. There is usually a very high correlation between the prevailing long-term trends in commodities prices and interest rates. As commodities power higher in a bull market, interest rates often march higher in lockstep.
Rising interest rates are one of the most feared economic developments by stock and bond investors, for good reason. Increasing costs of capital relentlessly drag down the prevailing market prices for both equity and debt investments.
For both stock and bond investors, rising interest rates reduce the amount of capital bidding on these investments. As capital becomes more expensive and the yields attainable in alternative destinations like short-term Treasuries and cash rise, less capital is funneled into stocks and bonds. With decreasing demand chasing a relatively stable supply of these investments, equity and debt prices are forced lower by the free markets.
Rising interest rates also reduce the acceptable valuation levels for stocks, leading to further selling as investors try to avoid being trapped in overvalued positions. Although today’s popular interest-rate valuation theories for general equities are unbelievably flimsy and not historically accurate, they are still widely believed. Rising rates will wreak havoc on these modern-day rationalizations for chronically overvalued markets.
Rising interest rates directly hammer bond investors. As fresh new debt is issued at ever increasing market rates of return, existing debt with lower yields is sold. This drives down the price of all bonds that are paying interest rates lower than the current free-market cost of capital. Rising interest rates are one of the most hostile economic environments possible for long-term bond investors.
So for both stock and bond investors, which together represent the vast majority of total capital deployed in the financial markets today, the specter of rising interest rates threatens to unleash heavy selling and falling prices. Many investors understand that interest rates cannot stay at nearly five-decade lows forever, but the general consensus is that rising rates are way off into the indeterminate future, 2005 or beyond, and hence are not a clear and present danger to capital.
Today’s powerful commodities bull suggests otherwise, however. The rising rates could come sooner rather than later, decimating stock and bond prices.
Our graphs this week highlight the strong positive correlation between commodities prices and interest rates, showing why interest rates are probably due to start heading higher well before most investors are now anticipating. They also reveal a current anomalous divergence between the CRB and interest rates which is almost certainly unsustainable.
For a free-market interest rate to compare to the CRB Commodities Index, we used the yield on 10-Year US Treasury Notes. Unlike the short end of the yield curve dominated by Fed manipulation, the 10y Treasury long rates are truly set by free-market supply and demand. These long rates are largely immune from central-bank jawboning and even short-term interventions.
Along with the CRB and the 10y T-Note yield, this chart is divided up into zones in order to show the mathematical correlations between these two sets of monthly data. The yellow zone lines are drawn at every major interim CRB high and low of the past 25 years or so. The yellow numbers reveal the actual correlation of these datasets within each zone.
As both a visual scan and the actual zone correlations reveal, interest rates tend to move in unison with commodities through major bull and bear markets. As we are now in the third greatest commodities bull market in modern history, the current lethargically low long rates are quite anomalous.
For well over a quarter century now, the positive correlation between commodities and interest rates has been very strong. When commodities are strong interest rates are generally rising, and when commodities are weak interest rates usually fall. The hard mathematical correlation numbers confirm this visual evidence, with some very high results for years at a time during major commodities bull and bear trends.
Interestingly these correlations were highest during bear markets in commodities. In the mid 1980s, early 1990s, and late 1990s, multi-year correlations of 0.90, 0.88, and 0.92 were witnessed. These are very high numbers as far as financial-market correlations go, emphasizing the strong relationship between general commodities prices and long-term free-market interest rates outside of the Fed’s sphere of dominance.
The mathematical correlations were a bit lower during bull phases in commodities, but they are still significant running as high as 0.82. Visually the degree of parallelism in interest rates during commodity bulls is even more impressive than the correlation numbers would suggest. While all of the little peaks and valleys month-to-month did not necessarily line up like a key in a lock during these bulls, the general trend in interest rates was still usually up while commodities were rising.
This strong correlation makes great intuitive sense as well. Many of the same macro fundamental factors that drive commodities also drive interest rates. The primary example is inflation.
When the Fed grows the money supply faster than the general economy is growing, relatively more money chases relatively fewer goods and services, driving up prices. This monetary inflation often becomes apparent first in commodities, especially the precious metals which are classic inflation hedges. As investors slowly start to realize that general prices for living are rising rapidly all around them regardless of what government statisticians claim, their investment preferences gradually shift.
As these rising prices cut into the purchasing power gained each year in bonds and other debt investments, investors start selling these instruments to earn higher real returns elsewhere. Falling bond prices lead to rising interest rates, as a given bond pays a constant stated cashflow stream regardless of its current prevailing market price. As a bond is sold off, its price drops but its interest payments remain the same, so its effective yield rises for a new purchaser.
Thus when too much money is created and general prices are driven higher by inflation, commodity prices rise and fixed-income investors sell to avoid the coming carnage. While inflation is not the only link between commodity prices and interest rates, it is certainly the primary one.
After all, money itself is ultimately just another commodity. The price of money, interest rates, rises and falls with supply and demand. The supply of money in fiat currency regimes generally perpetually rises, but it can sometimes fall too, albeit rarely. When the prices of the 17 component commodities in the CRB are charging higher in a bull market, it is not surprising that the price of that universal exchange commodity known as money rises too.
Jumping back to our chart, the recent massive disconnect between the price of money and the price of the commodities of the CRB is very intriguing. Since the CRB bottomed in late 2001, 10y Treasury yields have actually had an extraordinarily negative correlation of -0.67. Negative correlations mean that interest rates have not only not been moving much with the CRB, but they have actually often been moving in the opposite direction! Very odd.
One potential clue to explaining this mystery may lie in the only other zone registering negative correlations between the CRB and the 10y Treasury yields. It happened over two decades ago in the early 1980s when these two monthly data series were negatively correlated at -0.42. Examining this event visually offers some interesting insight.
The CRB index reached its all-time monthly high near 335 in November 1980. At the time commodities were the only game in town and a speculative mania in precious metals was underway. Gold and silver had been soaring but general equities were loathed at rock-bottom valuations, and rising interest rates throughout the 1970s had decimated long-term bonds as well.
A natural human tendency long plaguing investors and speculators is our inherent desire to extrapolate present conditions into the undefined future. We see this all the time in the markets. If the stock markets are soaring like they were just a few months ago, the vast majority of players assume the trend will continue up indefinitely. Contrarians play off this predictable human tendency all the time, selling when nearly everyone seems convinced markets will go higher and buying when practically everyone is convinced they will fall to zero.
This psychological inertia is directly proportional to the length of time a given trend has been in force. A rally lasting a month will generate a lot fewer true believers than a rally lasting a year, and both will be dwarfed by the faith that a rally lasting a decade will produce. Naturally this psychological inertia is also strongest near major long-term trend changes, when the long-standing market status quo is being challenged yet few are willing to recognize it early.
Provocatively, the only two negative correlation zones between the CRB and 10y Treasuries occurred around the only two major long-term secular trend changes in the CRB. Psychological inertia could explain why money prices lagged commodities prices in both of these instances, two decades ago and today.
The early 1980s negative correlation zone occurred right after the all-time CRB high following a decade-long superbull in commodities. At the time the vast majority of investors believed that commodities were the wave of the future and only a relatively few contrarians thought a major trend change was even possible, let alone probable.
Reflecting this dominating worldview, the price of money continued spiraling higher even after the commodities bull had peaked. It seemed to take about a year as well as a 20% drop in the CRB before inflationary fears began to abate and long rates finally started heading down like the rest of commodities prices. The psychological inertia after a decade-long commodities bull was immense and required lots of market evidence to the contrary to break before the realization of a major commodities top started to set in.
Today, during the only other negative correlation zone between the CRB and 10y Treasuries, we face a similar long-term secular trend change. After a two-decade Great Bear market in commodities, the majority of investors today are just conditioned to think commodity prices should fall forever. The psychological inertia generated by a multi-decade downtrend is absolutely enormous and requires a serious amount of contrary market action to break.
So, even after commodities started marching higher again in late 2001, long rates continued lower along their multi-decade trend. Investors just expected interest rates and commodities prices to continue falling into the indefinite future along their existing long-term trends. I am sure you remember the dizzying CRB lows first witnessed in the late 1990s, when crude oil plunged to $11 per barrel and most folks thought the world would never again witness any commodities scarcity.
If psychological inertia did indeed carry long rates lower even after the CRB turned up, the accelerating secular bull in commodities is proving that this is the real deal. Every day more and more stock and bond investors start paying attention to commodities, as a 53% bull market in the CRB demands serious respect. Gradually bond investors will start to understand the deadly implications of a commodities bull and inflation to their extensive investments, and some will begin to sell.
This bond selling by countless investors will drive down bond prices and drive up yields. As these long rates continue to rise, more and more bond investors will get the message and the selling will intensify. The rising interest rates will feed on themselves and beget even more bond selling, pushing rates even higher.
First though, the CRB bull has to grow prominent enough to burn through the huge psychological inertia left by a multi-decade bear market in commodities and interest rates. With each passing month and every new multi-decade CRB high, the case for a major long-term trend change to a secular Great Bull in commodities grows stronger and stronger.
Just as it took a year or so for the bond markets to catch up with the CRB trend change of the early 1980s after a decade-long commodities bull, it is not too surprising that it is taking a couple years or so for the bond markets to catch up with the latest CRB trend change of 2001 after a multi-decade Great Bear. The longer the major trend, the greater the psychological inertia and the harder it is for investors to accept a trend change.
Our next graph zooms in to the recent secular trend change in our current commodities bull. Using daily data this time, this current CRB/10y Treasury decoupling is running at a -0.679 negative correlation, almost identical to the monthly data above.
There have been two distinctive uplegs in our current CRB bull, the first starting in late 2001 and the second last summer. It is really interesting that long rates spiked up rather dramatically at this scale near the beginning of both of these uplegs. Yet, as the CRB uplegs accelerated, the long rates topped and soon rolled over and fell for much of the remainder of each upleg.
While not evident on this chart, it is really interesting that these long rates correlate highly with the US Dollar Index. So far in this commodities bull market, currency trading has exerted a greater influence on long rates than that of the usual commodities. Long rates were higher when the dollar was strong and fell when the dollar weakened. This relationship does make intuitive sense, as foreign investors should want to buy more dollars to buy US Treasuries when yields are higher, and buy less dollars when US yields are lower.
While the correlations are clear, the causal chain is not. Lower interest rates lead to lower foreign dollar purchases and lower dollar prices. Lower dollar prices lead to higher gold prices, since gold is a competing global currency, the ultimate real money. Rising gold helps lead major commodities uplegs. The falling dollar also increases oil prices, as oil producing nations are not willing to sell oil at cheap nominal prices when the real value of the dollar in the global markets is falling.
Since the CRB commodities are denominated in dollars, and the dollar yields as represented by the 10y Treasuries are constantly moving, the interrelationships between interest rates, commodities, and the dollar are complex and bi-directional over the short-term. Yet, when we zoom out and look at the big picture, it is crystal clear that interest rates tend to move with commodities. The short-term decoupling anomaly witnessed above is the exception, not the rule.
If this decades-old relationship continues into the future, which is likely once some critical mass of bond investors realizes that this commodities bull and monetary inflation is the real deal, interest rates are going to follow the commodities higher. Rising long rates are very dangerous for today’s overvalued stock markets and today’s bond markets with interest rates hovering near half-century lows.
While rising rates threaten conventional investments, the primary beneficiaries are the easiest commodities in which to invest, the precious metals. Gold, silver, and platinum are already in primary bull markets and are destined to run much, much higher before this secular commodities bull exhausts itself.
When interest rates overcome the psychological inertia of their long bear market and start following commodities higher, the trickle of capital pouring into the precious metals now will gradually grow into a flood. Rising rates will decimate bond prices and make already overvalued stocks look even more bubble-like. Rising rate environments inexorably force bond and stock prices lower over time.
Investors with capital deployed in stocks and bonds, the vast majority of all capital today, are not going to be happy watching stock and bond prices decline in the face of rising long rates. Just as in the late 1970s, rather than taking a pounding in intangible paper assets, many will migrate into precious metals to ride ahead of the inflationary wave of currency growth and increasing interest rates.
Once a major secular trend change in commodities and interest rates occurs, the new bull or bear market usually runs a decade or more in history. Today’s new commodities bull and coming interest-rate bull are likely to have similar long-term durations.
If you are interested in riding this awesome commodities bull as an investor and speculator and you want to protect your long-term investments from the coming scourge of rising interest rates, please consider subscribing to our acclaimed monthly Zeal Intelligence newsletter. We have been long this entire commodities bull and are always searching for new investment and speculation opportunities as it continues powering higher.
All conventional investors in stocks and bonds really need to carefully consider the dire implications for their portfolios of the high probability of rising long rates. Commodities are already galloping higher, and odds are that interest rates will soon follow.
Today Wall Street continues to act like nearly half-century interest-rate lows will persist into the indefinite future, but as every contrarian instinctively knows betting on an extreme existing into perpetuity is the height of investing folly. Interest rates have been stretched to incredible lows, and rising commodities are already heralding their inevitable rebound much higher.
Adam Hamilton, CPA March 26, 2004 Subscribe at www.zealllc.com/subscribe.htm