Treasury Yields vs. Commodity Prices

From 1980 until the spring of 2002, 10-year Treasury note yields held a positive correlation with the CRB index. Since 2002, however, there has been a dramatic divergence between Treasury yields and commodity prices. This trend is unsustainable in the long term because bond yields must eventually reflect rising inflationary pressures and at some point offer a positive real after-tax return.

There can be only two possible conclusions reached when viewing this disparity, shown in the chart below. One is that commodity prices are no longer an indication of inflationary pressures, a ridiculous contention that cannot be taken seriously. After all, the CRB Index contains 19 commodities that include precious metals, base metals, agriculture and energy, broad measures of the pricing pressures that exist in today's economy.

The other conclusion-the right one, in my estimation-is that Treasury securities are grossly overvalued.

Source: Bloomberg

[The 15-year chart above shows the close relationship that existed between 10-year yields (shown above in white) and the CRB index (green) from November 1993 into 2002. The decoupling since that time can clearly be seen here.]

Today's disparity between rising bond prices and inflation are likely the result of bondholders' fears of holding any debt not backed by the full faith and credit of the U.S. government, but this is a not a disparity that should be able to continue indefinitely. After all, even according to the "official" inflation measure--the Consumer Price Index, which likely understates inflation--buyers of 10-year treasuries are currently getting a negative real return to the tune of nearly a full 1%!

History is clear that we should look for a reversion to the mean, either via a dramatic downward break in commodity prices, a sharp increase in Treasury bond yields or some combination of the two. It is my belief that the continued actions undertaken by the Fed to re-liquefy the banking sector will engender a further increase in inflation pressures and send commodity prices higher still.

As a result, the most likely outcome in this scenario is for a collapse in bond prices as opposed to a dramatic retrenchment in commodities.

In the current economic environment, rising interest rates would exacerbate the decline in home prices and restrict credit availability even further, thus the Fed will be unable to hike rates until any economic recovery is well underway. So, despite the incessant claims over the last few days that commodities are "in a bubble," the risk of falling bond prices far outweighs the risk of falling commodity prices.

While it may be true that commodities are a little overbought on a short-term basis, today's real bubble exists in the bond market.

Comments

[ikkyu]

Really nice analysis. Thanks!

[sliman]

Mike
Thanks for the article. I am long all the Ag stocks and natural resources. What is the best way to bet long term rates will go up? ETF?

[jurp]

I notice gold up 50 times, and houses also, since the depression. Given that, I believe the party will end when americans stop buying goods from china, india, etc.

Their GDP's will decline, commodities will decline, and bonds will be king again.

The author has see 2% goverments, (1945), 14%, and now 5%.
Yes, they will go to 6%; but not any more.

Why, wages are not rising, surplus labor can not buy high priced commodities.

Commodities will drop 25%, wages drop 5%, bonds 6%, house drop
another 10-15%.

Wait it out, in foreign short term bonds. JRP