Last week I was up in arms about inflation (or its lack thereof), and how it could affect our dearly beloved commodities. This week (is no different from any other week in that) I’m trying to get my head around what’s happening in general markets, and am currently pondering equities and bonds.
My interest is piqued by the aforementioned two tinkers, because if I can figure them out, I can color my paint-by-numbers portrait of the economic landscape, and join the dots on my canvas of commodities. There is method in my madness: equities have recently been a shepherd to commodities, specifically crude oil (for the last year, everywhere that equities went, crude was sure to go). As for the bond market, it is a barometer of both risk appetite and inflation expectations - both key influences on commodities.
So here’s the scoop; while equities are looking like they are topping out (=risk aversion rising), I look to the bond market (and specifically Government debt) – which historically has an inverse relationship with equities (equities = risky, bonds = safe) - to give some indication for future growth and inflation. So hence in this current environment, equities and bonds = Pinky and the Brain.
‘So what’s the big deal about the bond market?’ I hear you ask. (I will now try to avoid being super-dull and muzzle the market-nerd in me). Essentially the bond market is considered to be the wisest of all asset classes. The Brain, if you will. One of the most famous quotes about the bond market was made by James Carville, who famously quipped “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everyone.” This is because the bond market tends to be the voice of reason when other asset classes are losing their heads. For example, the change in 2-yr Treasury yields is a good way to gauge economic sentiment; they will rise as optimism grows (because expectations increase for a higher interest rate), or vice versa. As for 10-yr Treasury yields, they provide an indicative view on longer-term inflationary expectations. There are many factors that go into the bond market - too many to put onto the chopping board right now (quantitive easing and gaping budget gaps are current quandaries…while bond guru Bill Gross highlights further problems here) but my main take-away is that the bond market is a tool to assess the outlook for near-term growth and inflationary pressures, which we can then apply to our outlook on commodities.
I have faith in the bond market. Like the Brain, it is deadpan, composed and smart. As for equities, all I have to say is P to the I, to the N-K-Y. They are scatter-brained, emotional, and seem to enjoy being hit over the head. And as life imitates art, the bond market is always teaching equities a lesson, time and time again.
So to draw this tail (I tried to resist) to an end, both of our heroic characters in today’s story could be bearish influences over the coming months. Equities could potentially scurry lower, while bonds yields are resisting the apparent urge to scamper higher (=prices lower) as deflationary or double-dip fears could develop. With these potential headwinds, commodities are likely to find it increasingly tough to take over the world, tonight, or any time soon.