INTERMARKET ANALYSIS
Commodities And The Inflation Rate
by Alex Saitta
Which individual commodities have the strongest coincidental relationship with the inflation rate?
Successful traders need to keep an eye on commodity price changes to gain insight into the latest changes in the inflation rate and anticipate the next bond market move. You cannot rely on the monthly Consumer Price Index (CPI) report, since there is a considerable lag between the period when the data is collected and the date the report is released to the public. By the time you get it, it's too late.
FIGURE 1: AVERAGE CORRELATION AND DEVIATION. Commodities that fall in the bottom right-hand corner are those with the strongest and most consistent relationship to inflation.
Here's a technique to identify the commodities that display the strongest coincidental relationship with the inflation rate. This eliminates the need to watch all commodities markets and allows you to focus on those that are significant.
STUDY
I used correlation analysis to study the strength of the relationship between commodities and inflation. I selected 16 widely traded commodity futures markets that update in real time and are widely available to traders. Correlation analysis measures how well two variables move together over time, and it results in the formation of a statistic referred to as the correlation coefficient. The coefficient ranges from -1.0 to +1.0 and identifies the direction as well as the strength of a relationship between the two variables.
A coefficient of +1.0 marks a perfect positive relationship. This means that when one variable rises, the other rises in lockstep. When one falls, the other falls in lockstep. A coefficient between zero and +1.0 is a nonperfect positive relationship. When one variable rises, usually the other rises. When one falls, typically the other falls. When the coefficient is less than zero, a negative or inverse relationship exists. A coefficient of zero indicates there is no relationship at all between the two variables, so when one variable changes, it is equally likely the other variable will rise or fall. (For a detailed discussion of the calculation of the correlation coefficient, see sidebar, "Correlation coefficient calculation.")
I examined the relationship between each commodity and the inflation rate as measured by the percentage change of the CPI of the prior 12 months. The steps are:
1 Divide the past 20 years into five periods of four years each.
2 For each of these five periods, calculate the correlation coefficient between each commodity and the inflation rate.
3 Take the average of the five correlation coefficients for each commodity.
4 Calculate the average absolute deviation of the five coefficients from the average coefficient. The smaller this deviation, the more representative the average coefficient is of the five coefficients and the more consistent the commodity's relationship with inflation.
Suppose I am analyzing the coefficients of two commodities, ABC and XYZ. Suppose in each of the five periods, I discovered that ABC commodity had coefficients of +0.50. Then suppose I discovered that XYZ commodity had coefficients of +1.0 in the first and second periods -- a perfect relationship. Then in the third and fourth periods, XYZ had no relationship with inflation -- zero coefficients, and in the final period, the coefficient was +0.50. The average coefficient of both ABC and XYZ equals +0.50. However, ABC's relationship with inflation would be more consistent over time.
Contributing Writer Alex Saitta is a technical analyst and vice president for Salomon Smith Barney. Yuxin Li contributed to this article.
Excerpted from an article originally published in the July 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.
Return to July 2000 Contents