Another Divergence: Commodity Prices and Bond Yields

Recently it has been discussed how the traditional 7-8 multiple of crude oil to natural gas has broken down - or at least how natural gas has not caught up as crude continues its march well beyond $100 a barrel. It was further speculated that this may be a buying signal for natural gas and natural gas stocks - even with the recent run up in prices. As it turns out, commodities and bond yields, which have also more or less moved in tandem over the years, have also been gaping apart - with the gap holding for a significant period (approximately the last 5 years), and with the spread between the two continuing to increase. Why do they typically move together? Simple. When commodity prices rise, inflation begins creeping into the system. Anytime inflation increases, bond investors will demand higher yields, causing commodity and bond yields to move together. A simple sector shift from bonds to commodities puts selling pressure on existing bonds, further driving up yields.

So the trade seems easy - short commodities and bonds (driving yields up). Simple, right? Well, maybe not. Others examining the divergence list potential problems with this logic. First, things have changed. Commodities are now believed to have less influence on inflation (not that demand doesn't cause inflation, but that demand is not necessarily scaled back due to price increase). Regardless of prices, people need energy and raw materials. Second, we are in a commodity bubble. Bubbles burst, but we don't know why or when. To the first point, we often hear the refrain: "it is different this time." No, it is not - or at least, usually, it is not. Things may be a little different, and timing may be off, but long-term trends tend to have a way of popping back up and reminding us of efficiencies, and of our own stupidity and greed. As for the second comment - I agree. Even if we know a bubble exist, we don't really know when it will pop. Furthermore, when it does pop, it usually takes longer than we expect. What shall we do? We probably need to sit back and wait for more clarity, at least before taking both sides of the trade looking for convergence. Once the commodity boom stalls and takes a breather in its historically long cyclic move, investors will have less profits to redeploy (such as in the bond market), at which point the selling and stalled buying pressure on bonds should start driving the yields back up. For those that do take both sides of the trade, let us just hope that the old axiom of Wall Street - that our capital last long enough to allow the market to see how smart we are - gives us a reason to laugh and gloat, instead of a reason to cry.