Start Thinking About Inflation

Start thinking about inflation. And when you do, think about oil and gas, the top commodity driver of price growth. Among all long-only commodity exchange traded funds, these have the most exposure.

Several long-only commodity exchange traded products signaled bottoming action ahead of the September Federal Open Market Committee meeting. Such technical uniformity is significant, given the diverse index methodologies and track records.

Oh, I hear your doubt: “Commodities? Really? With inflation barely readable?”

It’s true that inflation has been sluggish, but there are signs of that latency giving way. The slack in the labor market, according to Fed chair Janet Yellen, has largely disappeared and is gradually pushing up wage and price growth. 

And then there’s the inflation surprises, most particularly in the Eurozone. Inflation in the zone has beat economists’ expectations in the past 12 monthly reports. Indeed, the upswing in global economies helped spur the Fed to crank up domestic rates earlier this year. How soon before we see consistent inflation surprises on this side of The Pond?

Investors assume a direct correlation between commodity prices and inflation. But research shows that only certain commodities, not commodities in general, have a significant impact on inflation as measured by the Consumer Price Index. When the Bureau of Labor Statistics analyzed price movements in four commodities—crops, animal slaughter and processing, dairy, and oil and gas—only the petroleum products substantially contributed to inflation. 

Figure 1 portrays the correlation between changes in the CPI inflation rate and prices for West Texas Intermediate crude oil. Since 1987, the correlation is 52 percent, four times higher than the coefficient for gold—the commodity most commonly touted as an inflation hedge. Over the past five years, oil’s correlation to CPI is even tighter—87 percent. Put into another statistical context, three-quarters of CPI’s movements can be explained by oil. For gold, the explanation rate, known as the R2 coefficient, is a mere 3 percent.

(Click on image to enlarge)

So, if you’re banking on inflation to drive the price of your commodity index product, you’re better off—all else held equal—finding the one in which oil has the greatest influence. It’s worth a look at the exchange traded commodity index funds with the longest track records to see how they’ve tracked inflation. (We’re going to ignore a couple of commodity index exchange traded notes because their carried credit risk can influence pricing.)

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Disclosure: Brad Zigler pens's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) option ...

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