COMMODITY PRICES ARE RISING FOR FIRST TIME IN TWO YEARS -- THAT'S GOOD FOR COUNTRIES LIKE CANADA THAT PRODUCE COMMODITIES -- BUT POTENTIALLY BAD FOR BONDS -- WHILE WEATHER IS BOOSTING SOME COMMODITIES, COPPER IS LAGGING BEHIND
COMMODITY INDEX IS TURNING UP ... With the stock market running into a little resistance around its old high, and bond yields stuck in the middle of a trading range, the biggest intermarket story this past week was the 2014 climb in commodity prices. I wrote about this on Wednesday, but want to spend more time on it today. The weekly bars in Chart 1 show the Reuters/Jefferies CRB Index climbing nearly 3% on the week to end above 300 for the first time in a year. [The CRB Includes includes 19 actively-traded commodities]. The fact that the CRB bounced off chart support at its mid-2012 lows adds credibility to the recent upturn. Weather is also playing a role with the two biggest gainers being coffee and natural gas. Natural gas is benefiting from the unusually cold winter, while coffee is gaining because of a drought in Brazil. Even with that caveat, the commodity rally has been broad-based. Year-to-date gains have also been seen in other energy markets, precious metals, grains, livestock, cotton, orange juice, and tropicals (cocoa and sugar). While some of them may also be weather-related, there's also the possibility that the commodity upturn may be an overdue reaction to a stronger global economy. That's not necessarily a bad thing. Global central bankers are concerned about the threat of global deflation. They'd be happy to see some signs of inflation, which usually show up first in rising commodity markets. That's usually a sign of economic strength.
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Chart 1
COMMODITIES USUALLY BOTTOM AFTER STOCKS ... Historically, a relationship exists between stocks and commodities having to do with the economic cycle. At major tops (and the start of recessions), stocks usually peak before commodities in anticipation of a recession. Commodities drop once the recession takes hold. Stock usually bottom midway through a recession and are the first to rally. It usually takes some time for an economic rebound to take hold which starts to build inflation pressures. That's when commodities usually turn up. That's usually a sign that a stronger economic recovery is underway. The monthly bars in Chart 2 compare turns in the S&P 500 to the CRB Index over the last decade. Both rose together until mid-2007 when stocks started to drop. The commodity peak didn't take place until mid-2008, nearly a year later. Both dropped together until 2009, before bottoming together that spring. [In my most recent intermarket book, I explained that the closer correlation between stocks and commodities that year were due to deflationary pressures resulting from the collapse in housing]. The two markets decoupled during 2011. Over the last three years, commodities have dropped while stocks have risen. Historical intermarket patterns suggest that commodities should be the next asset class to turn up. And they appear to be doing that. The Correlation Coefficient (below chart) shows their relationship turning negative in 2007 and 2012, and positive in 2004 and 2009. The last up arrow to the bottom right suggests that their relationship is starting to turn positive again. That should benefit commodities and stocks tied to them. It may also start to benefit countries that produce commodities -- like Canada.
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Chart 2
CANADIAN STOCKS ARE GAINING ... The monthly bars in Chart 3 show the Toronto Stock Index ($TSX) climbing to the highest level in three years after breaking through a resistance line drawn over its 2008/2011 highs. That's a bullish sign for a market dominated by natural resource stocks. I have to suspect that the recent upturn in commodities has something to do with that. The red line just above the bar chart plots a relative strength ratio of the TSX divided by the S&P 500. That line peaked in 2008 along with commodities. It's also been dropping over the last three along with commodity prices (see CRB Index in top box). If commodity prices are turning higher, Canada's stocks should also do better -- both on an absolute and relative basis. They've already started doing that. During the first two months of 2014, Canadian stocks have gained 4.3% while the U.S. S&P 500 is down -0.66%. [And the U.S. men and women still can't beat Canada in Olympic hockey].
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Chart 3
RISING COMMODITIES ARE BAD FOR BONDS... Although the relationship between bonds and commodities has sometimes been skewed during the deflationary cycle of the past decade (and Fed policy), they may be starting to revert to their more normal relationship which is to trend in opposite directions. Since rising commodity prices are an indication of rising inflation, the usual result is lower bond prices and higher yields. Chart 4 compares the CRB Index to the price of the 10-year Treasury Note since 2008. During that deflationary year, bond prices rallied while commodities plunged. That's normal. A commodity bottom in 2009 coincided with a bond drop that lasted for a year (also normal). A commodity rise during the second half of 2010 produced another bond pullback. A bigger commodity drop between 2011 and 2012 help produce bigger bond gains (normal again). A lot of the bond gains since 2008 have been supported by the Fed's policy of quantitative easing. A sharp drop in bond prices during 2013 resulted from the Fed's talk about tapering its bond buying program. As a result, bond and commodities fell together last year (which is not normal). That probably had more to do with Fed policy than traditional intermarket relationships. Commodity prices now appear to be turning higher after going through a bottoming period beginning in mid-2012. If that commodity rally continues to build throughout 2014, the natural intermarket result would be for even lower bond prices and upward pressure on bond yields. In time, rising inflation pressure could tempt the Fed to start raising short-term rates which would push bond yields even higher. It's probably way too early to start thinking about that. But rising commodity prices could accelerate a quicker end to the Fed's unprecedented accommodative monetary policy. And markets have a uncanny ability to anticipate those policy changes way in advance.
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Chart 4
COPPER IS LAGGING BEHIND... My Wednesday message listed copper as one of the commodities that had gained recently, and showed a copper ETF testing overhead resistance. I'd like to elaborate on that further here, and draw some larger conclusions from the copper action. First, a chart of the actual copper market. [Commodity prices and their respective ETFs sometimes differ, which is why it's always better to look at the actual commodity]. The daily bars in Chart 5 show the price of spot copper rising during February, but still down for the first two months of the year. In addition, the copper/CRB relative strength ratio (below chart) has plunged during the first two months of 2014. [Weakness in Chinese stocks may have contributed to copper weakness, since China is the world's biggest importer of that commodity]. Here's why that's important. Of the 19 commodities in the CRB Index, copper is most sensitive to global economic trends. [Hence the name "Doctor Copper" and jokes about it having a PhD in economics]. Commodity rallies are more believable (and have a stronger economic message) when economically-sensitive markets like copper (and energy) are leading it higher. Right now, energy is doing its part. Copper isn't. Historically, copper has also had a positive relationship with stock market trends, since both benefit from a stronger economy. The moral of this story is that copper is going to have to start acting a lot stronger for the rally in the CRB Index to be truly carrying a positive economic message.
