I've been doing this chart of the week column for a few months now, but I don't think I've presented a chart as important to Canadian investors as this one. The relationship between U.S. real interest rates and commodity prices looks innocuous at first, but I firmly believe the future course of this chart will be a main determinant of Canadian investor portfolio performance in the months ahead.
I lifted the idea for this week's chart from hedge fund manager and former U.S. Treasury economist Mark Dow. Mr. Dow believes that even though we've already experienced a painful correction in commodity prices, rising U.S. real interest rates will cause a second wave of declines.
"The first shakeout was mostly tourist dollars getting shaken out of the gold tree. The second phase will come as higher real rates drive the wooden stake the rest of the way through [commodity prices], shaking out the long term money, the asset allocators and the true believers. And based on the charts …, if this is not happening now, it is likely to happen very soon," Mr. Dow writes.
Our chart compares the yield of the U.S. five-year Treasury Inflation Protected note with the Continuous Commodity Index, which includes energy prices.
SOURCE: Scott Barlow/Bloomberg
The inverse relationship – commodity prices fall as real rates rise – is clear both visually and with correlation math (the r-squared is exactly 0.50). There are two reasons for this. One, rising real rates attract yield-hungry foreign capital into the U.S. bond market. This pushes the greenback higher, and commodity prices valued in U.S. dollars, lower.
The second reason for the relationship is that higher interest rates also make safe, yield-producing assets like U.S. Treasuries more compelling. This often leads to a wave of portfolio de-risking, which is potentially the more pernicious of the effects for Canadian investors.
China's rapid economic growth has been the main driver of rising commodity prices over the past decade, and returns in resource stocks have more than compensated investors for the sector's typically high levels of volatility.
With China slowing, and global production of many commodities at much higher levels, the supply and demand equation for resources is tilting away from positive performance. The relative safety of U.S. bonds is increasingly attractive as yields climb. For non-American investors, a rising U.S. dollar makes Treasuries even more compelling as an investment option.
These current trends create a host of risks for Canadian investors, even those without significant holdings in the near 40 per cent of the TSX made up of resource stocks. Rising real bond rates threaten returns in yield-bearing sectors like real estate investment trusts and utilities, where many domestic portfolios are overweight.
I'm not suggesting a Canadian market apocalypse is on the horizon, merely that domestic investors should follow the relationship between U.S. real yields and commodity prices closely. Domestic investors should carry more stable growth U.S. equities and less risk for as long as five year real rates continue to climb.
Investors who doubt the importance of yields in the current market environment should heed the words of Kevin Ferry, co-founder of Cronus Futures. After decades of successful trading in the depths of credit markets, Mr. Ferry recently bought a vineyard and re-located from Chicago to northern California.
On Wednesday, he tweeted, "We plant roses at end of vineyard rows to warn of disease....think of the 5-year [U.S. Treasury] that way."
Follow Scott Barlow on Twitter @SBarlow_ROB.