“In a crisis, all correlations go to one.” That’s one of the most painful lessons of the Global Financial Crisis. It certainly applied to commodities, which for six years have displayed notably high correlations among different sectors – energy, metals, agriculture, etc. – and, as a group, high correlations with equities. Determining appropriate hedge ratios and managing a hedge premium budget has become more difficult since the value of diversification as a risk management tool has declined. But now it appears that commodity correlation is itself beginning to fall off.
Princeton economists Ke Tang and Wei Xiong published a paper in 2012 (Index Investment and the Financialization of Commodities) arguing that the financialization of commodity markets through tradable indexes and other liquid instruments available to both institutional and retail investors pushed up correlations, starting in 2008. Commodities previously had prices set by supply and demand, but these new tradable instruments – index-based ETFs and ETNs, total return swaps (for institutions) and the like – brought financial speculators into the mix, and caused the commodity markets to be pushed around by technical factors.
The increase in correlation, according to Tang and Xiong, is statistically significant. One example they provide is how the correlation between energy and non-energy commodities had a long-term average of 0.1, but it rose to 0.7 during the financial crisis.
The Bank for International Settlements came to a similar conclusion as Tang and Xiong in a working paper last July (On the correlation between commodity and equity returns: implications for portfolio allocation), concluding, “At the same time, an investment strategy which also includes commodities in a portfolio produces substantially higher volatility and not always produces higher Sharpe ratios. This is at odds with the common notion that commodities serve as a hedge.”
In an interview with Energy Risk magazine in March 2012, Xiong elaborated, “In the long run, you would expect everything has to return to a level justified by supply and demand, but the issue is one of frequency, and whether this is going to happen sometime soon or not for many years, The amount of money in commodities means prices are more closely aligned with other asset classes, and there may have been a temporary additional jump in correlation after the financial crisis. But will it eventually go back to zero? I doubt it.”
But now things have reversed gears. In 2012, the United Nations Conference on Trade and Development issued a report that condemned the financialization of commodity markets, and called for further regulation to remove speculative players from the markets. UNCTAD economists wrote a report (The synchronized and long lasting structural change on commodity markets: evidence from high frequency data) in which they argued that US crude oil futures and US equity futures had a correlation – amazingly – as high as 1 in 2011, up from 0.2 in 2007. However, the same economists told Reuters in April 2014 that the correlation had dropped back to pre-2008 levels. (Influence of banks, hedge funds on commodities lowest since 2008)
One of the two UNCTAD economists, David Bicchetti, weighed in on the “financialization is bad” side of the argument in an interview with FT Alphaville in April. Alphaville wrote of Bicchetti, “…he does not think that just because correlations have now abated that this is evidence that the market has somehow been fixed. ‘The patient may not have one of the symptoms anymore, but that doesn’t mean he has overcome the sickness,’ he said, referring to the fact that the original research also reflected heightened reflexivity, or ‘herding,’ during the period.”
This phenomenon also caught the attention of the Wall Street Journal, which wrote (in “Stocks, Commodities Break Up the Band”), “…Both [commodity] indexes are well off the 10 percent rise this year of the Standard & Poor’s 500-stock index, which closed at an all-time high Thursday.”
So why is this happening? The usual suspect is the withdrawal from the commodities markets of many big banks and some hedge funds (see the Reuters article mentioned above). Bicchetti of UNCTAD told Reuters, “As financial investors including banks and hedge funds have reduced their activity in commodities markets in the last two years, we’ve seen a marked drop in the correlation between the returns on the equity markets and the returns on oil and other commodities futures markets.” Ironically, this explanation relies on a correlation to explain a lack of correlation.
Granted, FICC revenues were down an average of 20 percent last year, and one firm suffered a 40 percent drop as structural market issues and regulatory capital pressures began to bite in earnest. The commodities businesses began to appear as a luxury that would no longer pay off and a host of firms like JP Morgan and Deutsche Bank pulled in their horns. Only long-time commodity shops like Goldman Sachs, with its J Aron lineage, and Morgan Stanley, are expected to stay in the market.
These trends are cold comfort for Treasury attempting to hedge its exposures in an intelligent manner. Commodity prices and volatility spiked in 2005-2006, and correlations rocketed in 2008. The current return to normalcy, if one is to believe the financialization demonizers, could be short lived if commodity markets rocket again and investors chasing yield turn to energy, metals, ags and the rest. The withdrawal of second and third tier commodity houses like JPMorgan and Deutsche Bank might be a long-term phenomenon that pours oil on the commodity waters. But given the events of the last six years, it seems unwise for Treasury to build a strategy based on low correlation, no matter how attractive that may seem.