With the Baltic Freight Index reaching 3-year highs, U.S. ISM manufacturing data reaching 13-year highs, and U.S. equity markets reaching all-time highs, more people–including the FED–are starting to wonder where Inflation is in all this strong economic data, as we enter the final quarter of 2017. In this blog-post, I explore how the commodity sector can potentially monitor more efficiently & more effectively when inflationary pressures are returning in the financial-capital markets. And I focus-in on the VIX as one of my leading indicators.
In her opening comments of a speech on monetary policy late last month to the NABE Conference in Cleveland, OH, Chairwoman Yellen of the FED had this to say: “Key among current uncertainties are the forces driving inflation, which has remained low in recent years despite substantial improvement in labor market conditions. As I will discuss, this low inflation likely reflects factors whose influence should fade over time. But as I will also discuss, many uncertainties attend this assessment, and downward pressures on inflation could prove to be unexpectedly persistent. My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.” Wow, after having read this, I had to take a step-back for a minute; when was the last time a major central bank said that they may have gotten inflation wrong?
This got me to thinking even more seriously about how I approach the commodity sector heading into 2018, especially in light of the FED’s policy of a return to monetary normalization & winding-down of QE assets. It was these comments that helped lead to the following analysis. And while I have my own ideas regarding why inflation hasn’t increased, I’m going to focus more upon what I think could be a valuable tool in anticipating the return of inflation to the commodity sector…as early as 2018.
The Inverse Relationship Between Equities & Commodities Since The Great Recession
Chart 1 above shows us very clearly how the equities markets–especially in the U.S.–have had a strong negative (opposite) relationship to the commodity sector; this is fairly easily explained, in that the FED policy of QE strengthened the US Dollar against other major trading partners’ currencies, and with this strengthening, the financial markets “played” this as a deflationary factor–adding premium to assets that do well in deflation, while taking premium away from those who do well in inflation. With this in mind, I created Chart 2 below in order to support this analysis: in this chart, we see at the top a 26-week running correlation study of the S&P 500 Futures & the US Dollar Index. As you can clearly see, when these two have a strong negative (opposite) correlation–such as now–inflationary pressures are likely to be on the rise. And the bottom part of the chart, which shows the Goldman Sachs-S&P Commodity Index, does indeed show a favorable reaction in most of the cases where the correlation is strongly negative/inflationary. The contrary is somewhat true as well: when both the S&P 500 and the US Dollar are moving together and have a positive correlation, this tends to create a tougher environment on the commodity index. So, now, the obvious question is: why isn’t the commodity index rallying currently, given the correlation is -.9? Now you have some appreciation and feeling of how Janet Yellen and I may feel!
Could it be the emerging markets pulling-down the commodity sector?
Not this time around it would seem based upon Chart 3 below, which shows the TR-EM Asia Pacific Index and compares it with the Bloomberg Commodity Index (I wanted to look at another commodity index, not just one, in order to substantiate better the analysis.); we see that since 2017 began, while the TR-EM Asia Pacific Index [orange line] rallied past its 2015 highs & to the highest levels since 2010, the Bloomberg Commodity Index [purple line] trended lower. It is here that the analysis above wasn’t complete; after all, if the U.S. economy is improving, and the rest of the global economy is improving–as the IMF just noted in their World Economic Outlook update last week–then why isn’t the commodity sector moving higher and switching trend?
The Inflation-Volatility Index Nexus: The “Missing Link”
What I have noticed more recently & anecdotally over the past few weeks–as the new Trump Administration, NAFTA, & North Korea have interjected their influence upon the financial & commodity markets–is that, generally speaking, when Equities strengthen simultaneously with Commodities weakening, I have also noted oftentimes that there is a new All-Time low in the CBOE VIX. As a result of this, I added the VIX to Chart 3 in order to see if there was a corresponding, or at least supporting trend, with the weakening of the Bloomberg Commodity Index. Since the end of 2016–the exact period under question–we do indeed see a positive relationship between the VIX and the Bloomberg Commodity Index.
Digging deeper, let’s take a look at the VIX against the “gold standard” of inflation: Gold itself. I do this in Charts 4 & 5. In Chart 4, we see an overlay of the lead-month Gold futures against the VIX Index; and in Chart 5, I show the 52-week running correlation between the Dollar Index and lead-month Gold futures.
- Chart 4 shows us fairly recognizable weak relationship/similar trend between Gold and the VIX, especially since 2016–the key time period we’re really searching for answers regarding the lack of inflation.
- Meanwhile, in Chart 5, we see that the Dollar & Gold have kept their very strong negative relationship-correlation in-tact since the end of 2014.
The take-away from these two charts for me is key to the analysis for late-2017/early-2018 is that, because of the weak relationship between Gold & the VIX–yet the strong negative relationship between the Gold & the Dollar–the “Missing Link” here could very well indeed be the VIX not rising with Gold keeps financial markets in a “deflationary” mood. This would make further sense with the FED and monetary policy mostly being translated & transmitted through the Dollar price-action/trend.
It just could be that the market is waiting-on the VIX AND the Gold to rally together: that, then could be the transmission of inflationary expectations returning in the financial/capital markets!
The VIX IS THE NEW DOLLAR WHEN IT COMES TO INFLATIONARY BIAS
Two charts remain in this blog: the VIX & US Dollar Overlay Chart, and the VIX-SRW Wheat Correlation Chart.
- It is fairly amazing to see how these two seemingly different assets move in a similar trend between them–especially since 2007. Also very noteworthy is that this chart shows very clearly a recovery in the US Dollar since 2014, and while this recovery has stalled-out as of late last year, major support in the Dollar of 92.50 remains in-tact. Is this in large part due to the VIX remaining at such depressed levels? Is the VIX essentially telling the Dollar to remain elevated because it continues to make new all-time lows? I think that there is some relationship between these two, otherwise I wouldn’t suggest it.
- Looking closer at the agriculture space in commodities, Chart 7 shows an interesting feature related to the SRW Wheat Futures & the VIX: when matching-up major highs and major lows over the last 10 years in the wheat, there isn’t much to draw from when it comes to the correlation between the VIX and Wheat at that time those highs and lows were made. This probably helps keep me focused more upon the commodity indices & gold as to being more reliable indicators for projecting the possible turn in the VIX corresponding with a return of Inflation in the financial-capital & commodity markets (Having said that, the wheat highs of 1996 & 2008 corresponded with strong positive correlations with the VIX–both were moving higher in other words. This is something to keep in mind).