How Speculators Are Causing Commodities To Move In Tandem Like Never Before

Every time commodities move higher, speculators are unfairly blamed.

But that doesn’t mean the expanding role of speculators isn’t having some effect on the market — in fact, it would be weird if they weren’t.

James Hamilton points to a paper, which argues that the effect of speculation has been to increase the correlation of all commodities to each other. Essentially, various indices, which can be invested in directly, have turned commodities into an investment class, as they’ve never been before, and so everything from coffee to oil moves in the same way.

Although Treasury Inflation Protected Securities offer a hedge against an increase in the U.S. consumer price index, they don’t offer protection for foreign investors against depreciation of the dollar. Insofar as increases in the prices of commodities like oil may depress real economic activity, holding commodities as an investment also offers useful diversification against risks to equities. Particularly when interest rates are low, there is an incentive to hoard physical commodities as an investment vehicle.

The paper by Tang and Xiong proposes that the increased use of commodities as a financial investment accounts for the increasing correlation among commodity price changes over time. In support of that claim, they note the growing popularity of investment strategies based on the Goldman Sachs Commodity Index or the Dow Jones Commodity Index. Tang and Xiong document that correlations among commodities included in the indexes have increased faster than those not included. For example, one of the regressions they estimate relates the return on commodity i to equity returns, bond yields, the value of the dollar, and oil prices, where the coefficients are allowed to grow with time at different rates before and after 2004, and with different trends on these coefficients estimated for commodities included in indexes as for those excluded. The figure below shows their estimated time path for the coefficient on oil prices comparing the indexed and non-indexed groups.


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