The strong positive correlation between Bonds and Commodities is creating an unholy alliance and confusing investors.

Strange how markets work!

Just when we thought we had it all figured out, just when we became convinced that inflation would win the day, those damn Treasury Bills just refused to confirm our hypothesis.

There is a somewhat strange and almost unholy alliance developing between Bonds and Commodities.

Chart 1 - 10Yr Treasury Price vs. Crude Oil (green)

The theory is that rising commodity prices (we have used Crude Oil in our example) is price inflationary. That is, when raw material prices rise, the general price level rises along with it.

The Fixed Income markets are supposed to be hyper-sensitive to price inflation. Bonds are supposed sniff out price inflation and interest rates should rise rapidly as they discount the effect of an increase in price inflation.

Therefore, a well worn economic rule is that commodities should move inversely to Bonds.

Not so per the above chart. During certain periods - November 2006 to February 2007 and June 2007 to September 2007 - both Oil and Bonds moved together. Oil climbing on inflationary fears and Bonds from a flight to safety ala credit crunch.

Whereas we can only speculate as to why or how long these two markets move together (perhaps debt monetisation / a continued flight to safety from the real estate slump) we are fairly certain that in the long-term they will decouple and go their own separate ways.

Chart 2 - Long-term chart shows Bonds and Oil negatively correlated

Our guess is that with the propensity and willingness of the Fed to reduce rates further, a long Oil short Treasury position will win out in the end.

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