Why Commodity Futures Display Negative Correlation with Traditional Assets

Abstract

Investment world has well understood the diversification benefit of commodity futures index. But many portfolio managers still confuse about why and how commodity futures negatively correlate with traditional assets. The negative correlation stems from the unique risk/return character and different exposure to economic fundament. Understanding the fundamental difference between commodity futures and traditional assets will help a portfolio manager efficiently use commodity futures to diversify her investment. This article identifies three important sources to explain the negative correlation: different reaction to inflation risk, counter-cycle movement, and opposed exposure to event shock. As commodities price are important part of inflation, the future price of commodity futures tend to increase with inflation rate, causing a windfall return to long futures position holders. Commodity futures exhibit good capability to hedge against inflation risk. When business cycle moves to the stage of output growth over sustainable growth level, stocks and bonds markets are more likely to be suffered from the price rising of raw materials and the increase of interest rate. However, commodity markets show strong performance as supply is constrained by capacity limit and demand. Commodity futures returns tend to have positive exposure to event risk since the event shocks unexpectedly cut the supply of commodity and move the commodities prices up, causing a significant gain to long futures investors. These event shocks are expected to be negatively related to the financial markets as the expected returns will be reduced by the higher cost of raw material inputs.