Why You Should Sell Commodity Indexes

Dec.14.10 | About: Jefferies TR/J (CRB)

By Bob Bronson

It is a popular view that commodity prices rise during periods of negative real short-term interest rates (RSTIR), and that is somewhat true. However, commodity prices are driven more by trends than absolute levels of real short-term interest rates. In the charts below, see particularly the three-year period from late 2002 through late 2005, when RSTIR rose almost 50%.

But commodity investors anticipate the positive and negative levels in RSTIR by the trend in RSTIR rather than simply waiting to react to the positive or negative level in RSTIR, so the trend in RSTIR is much more important to commodity prices than the level of RSTIR.

The first two charts below illustrate the past 10-year history of the negative correlation of RSTIR cycle-trends to commodity prices, as reflected in the CRB index, especially during the past six, very cyclical years since the mid-'04 low in RSTIR.

For example, commodity prices rose from mid-'04 when the level of RSTIR was negative, but they kept on rising through mid-'06 even after the level of RSTIR turned and remained positive for almost a year.

Then after commodity prices rose 50% from late '06 through mid-'08 while RSTIR declined some 700 bp, commodity prices collapsed more than 55% into early '09 while RSTIR rose over 500 bp. This was very clear negative cycle-trend correlation.

Following that, the trend in RSTIR declined 350 bp while commodity prices rose almost 50%. Again, this was very clear negative cycle-trend correlation

Furthermore, careful examination shows that the negative, cycle-trend correlation between commodity prices and the trend in — more than the level of — RSTIR is quite clear not only for the 5.5 years through '09, but it was also applicable to the first 4.5 years illustrated in these charts.

Thus, while commodity price momentum and QE2 leads many to believe that the recently reasserted six to seven-month rising trend in commodity prices is supported by fundamentals and the quantitative concept of a still negative level in RSTIR, we definitely do not agree.

We believe that commodity prices are over-priced for a critically important combination of fundamental and technical reasons and that they are topping and will soon start declining in response to these forces. This includes the more powerful influence on quantitative traders and investors from recently rising nominal interest rate and the rising trend, rather than the still negative level, in RSTIR. The trend in RSTIR has risen over 200 bp over the past nine months, especially since nominal short-term interest rates are essentially zero- bound, despite the supposed downward pressure from the announced $600 billion of QE2.

Inflationary expectations are currently (see the third and fourth charts below), primarily due to anticipation of QE2 plus the "irrationally complacent" belief that the stalled, depressed level of growth in the economic recovery will regain strength. When these expectations peak and start declining again (more than zero-bound nominal short-term interest rates can), the trend in RSTIR will mathematically reaccelerate to the upside, which will be much more clearly bearish for commodity price indexes, but again like well after their bubble peaked at a much higher price level in mid '08.

Since our work suggests the CPI will eventually turn negative, but not because of higher interest rates since we expect them to decline significantly from their recent days' highs, but rather because goods and services deflation will reassert itself as the first of the after- shock, double double-dips fully take hold. This will cause the already rising trend in RSTIR (see the first chart below) to continue up and go above zero — conditions consistent with the popularly followed theory for declining commodity prices — we fully expect commodity prices will then accelerate their many-month decline going into a major collapse, completing the second downleg of the commodity-bubble bust that we've forecasted. Of course, this will be belatedly signaled for trend followers by the lagging blue line crossing below the even more lagging yellow line in the oscillator panel at the bottom of the second price chart below.

All of this is consistent with the inevitable end game in a deflationary economic Supercycle Winter. And for short term technical reasons, including an incipient one-month double top in the CRB, we now recommend selling, and selling short, commodity indexes. For less aggressive investors, we also recommend buying Treasury bills, notes and bonds — again — as we have repeatedly done for three decades during the Supercycle Autumn and Winter since their 1981 price lows and yield highs. See representative charts at the bottom here and as more fully explained here: "As Forecasted — A 12-Year Retrospective."

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The chart below is a good measure of the current inflation expectations of investors, as reflected in their purchase of Treasury securities compared to consumers' inflation expectations for one year later (the second chart below).

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Notice that consumer price expectations, as reflected by that component of the University of Michigan Consumer Confidence Index (thin black line in the chart below), are unsustainably above the better future expectations measure from the Federal Reserve Bank of Philadelphia. For almost two years, they're both trending in the wrong direction compared to the latest five-month downtrend in the CPI.

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Disclosure: No position