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The CRB and Long RatesAdam Hamilton
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 So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence, that details
exactly what we are doing in terms of actual stock and options trading based on
all the lessons we have learned in our market research. Please consider joining us each month for
tactical trading details and more in our premium Zeal Intelligence service at …
www.zealllc.com/subscribe.htm Questions for Adam?
I would be more than happy to address them through my private consulting
business. Please visit www.zealllc.com/financial.htm
for more information. Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually
increasing e-mail load, I regret that I am not able to respond to comments
personally. I will read all messages
though and really appreciate your feedback! 321gold Inc
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