commodities+and+real+interest+rates final ver3.41 2011.09.01

8/4/2019 Commodities+and+Real+Interest+Rates Final Ver3.41 2011.09.01

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THE IMPACT OF REAL INTEREST RATES ON THE

COMMODITY EQUITY RELATION

Robert Balan and Alessandro Gelli

[email protected]@diapason-cm.com

Commodities and Real Interest Rates

The story of commodities has its ups and downs, but the resilience of the asset class asserted time andtime again. From a virtual poor cousin of the equity and bond markets, commodities have sprung to theforefront as genuine alternative investments after a tumultuous decade in the financial markets radicallychanged the investments norms in equities and bonds. The investment horizons in these two asset classeshave to be reduced to a point where strategic and tactical considerations practically meld into each other a condition that is normally attributed to commodities.

It used to be that you invest in equities and bonds for the long haul, and you added commodities fortactical asset diversification or inflation hedging but now commodities are at the same footing as theother asset classes in its legitimacy as a true investment vehicle. And more than ever, commodities havebecome crucial as enhancer of beta (or creator of alpha, if you will) in a diversified portfolio.

That would have been unthinkable less than 10 years ago. Mineral and agricultural commodities wereconsidered pass as late as 2001 (when the commodities market bottomed). Anyone who talked aboutsectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was thenconsidered behind the times. In Alan Greenspan's phrase, GDP had gotten "lighter;" the economy wasbecoming weightless, "dematerializing." Agriculture and mining no longer constituted a large share of theU.S. "New Economy", and did not matter much in an age dominated by ethereal digital communication,evanescent dotcoms, and externally outsourced services. The Economist magazine in a 1999 cover storyin fact forecast that oil might be headed for a price of $5 a barrel (it was priced at $12 at that time).

Since then, of course, the Old Economy struck back, and we have seen tremendous increases in theprices of most mineral and agricultural commodities, many of them hitting records in nominal and evenreal terms. Oil is now at $80/barrel (and had been as high as $115 earlier in the year) and gold is just a

shade below $1,900 per ounce ($250.50 in 1999). Corn, once a humdrum grain staple, is trading at$7.35/bushel (it was priced at $1.50 per bushel in 1999).

Diapason Commodities Management

Special Report August 25, 2011


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Please refer to the risk and legal disclaimer at the end of the document 2

The outperformance of commodities since 2001, attributable to a perfect storm of political events andmacro-economic developments, provides us a peek of what to expect in the future as diminishing suppliesof basic staples and raw material resources collide with the needs of a rapidly expanding developingworld, and with the macro-economic forces unleashed by the collapse of the Great Credit Bubble of thefirst decade of the 2000s.

DCI Total Return

0

100

200

300

400

500

600

700

800

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Jan-99

=1

00

Source: Diapason

There is certainly a lot of merit to many of the explanations that have been offered for the rise in the priceof oil. One is the "peak oil hypothesis," and another is geopolitical uncertainty in Nigeria, Venezuela and-- above all -- the Gulf. The interaction of supply, demand, and perturbations provided by inventoryfluctuations in regional crude oil hubs: these factors can rightfully account for the short- to mediumoutlooks in energy prices.

Gold has risen sharply after two major equity crashes less than 10 years apart -- investors seek a safehaven for capital and again as the market contemplates the possibility of a third one looming in thenear-future. Corn prices have been impacted by American subsidies for biofuel; the same for sugar inBrazil. Agriculture products in South America have been devastated by the vagaries of nature andweather, and the alternating impacts of El Nino and La Nina.

There are many other special microeconomic factors that are relevant in other specific sectors. Thecommon denominator in all these (even for commodities that do not have futures classes) is broad steadyrise which suggest multiple causes that impinge on all commodity items. It cannot just be a coincidencethat all mineral, metal and agricultural prices have risen virtually across the board in cadence or insynchronization. Clearly, a host of developmental, political, natural, and macroeconomic explanation iscalled for to explain the broad phenomenon of the sustained rise in commodity prices seen so far.

One popular and obvious explanation since 2003 has been rapid growth in the world economy. Thestrongest growth has, of course, been coming from China and other recently minted manufacturingpowerhouses in Asia, but the expansion has been unusually broad-based -- including up to three yearsago, the United States and even a reinvigorated Europe. So growth has pushed up demand for energy,minerals, farm products, and other industrial inputs -- that is the prevailing macroeconomic rationale, andit is the case of probably the best one.


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However, this reigning explanation still looks incomplete, as the growth rationale does not completelyexplain some of the notable exceptions seen so far. We cite two periods which diverge from the growthfactor rationale, to illustrate the point why we believe there are other powerful forces at work. (See chartbelow).

First: during the summer of 2007, the U.S. economy started to slow down noticeably, and was about toenter into a recession. Despite talks of decoupling, it is clear that other countries were also slowing downat least to some extent. In its forecast for the following period, the IMF World Economic Outlook reviseddownward the growth rate for virtually every region, including China. The overall global growth rate for2008 has been marked down by 1.1% (from 5.2% in July 2007, just before the subprime mortgage crisis

hit, to 4.1% as of January 29, 2008). And prospects continued to deteriorate. Yet commodity prices foundtheir second wind over precisely that period -- up some 25% or more since August 2007, by a number ofindices. It was a spectacular performance unmatched yet by any asset class under those global growthconditions. (See chart above).

Second: in early spring of 2010 (March), the U.S. economy also started to slow after peaking at 3.94% inthe first quarter. However, commodity prices continued to rise sharply higher. This time, the talk wasabout how China and the rest of the Emerging Markets were "priming the pump" so to speak, andregardless of the outlook in growth the U.S. and Europe, commodity demand was going to escalate.Another round of decoupling talks ensued brought about by still respectable demand growth from theBRICs. Commodities at that period performed their sharpest climb on record -- more than 50% in lessthan a year. That happened despite a slide (and revaluation lower) of U.S. GDP growth to 0.36% in Q1

2011, and a Chinese GDP decline from 11.9% to 9.6%. (See chart above).

So clearly we can see that growth is not the only explanation behind higher commodity prices. There areother factors that can cause powerful spurts in price gains. How then can we explain the phenomenon ofcommodity prices going up while the economy turns down? One wouldn't want to try to reducecommodity markets to a single factor, nor to claim proof of any theory by a single data point, so clearlybroad macro forces are at work.

The developments of the last three years provided added support for a view Diapason has had for a longtime: real interest rates are an important determinant of real commodity prices (see chart on next page). Atcertain points in the business cycle, the level and direction of real interest rates can drive commodityprices temporarily out of synchronization with the direction of growth. As the two recent examples above

show, commodities can prosper even when growth has gone flat or growth has began to fall.


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High interest rates reduce the demand for storable commodities, or increase the supply, through a varietyof channels: by increasing the incentive for extraction today rather than tomorrow (think of the rates atwhich oil is pumped, gold mined, forests logged, or livestock herds culled); by decreasing firms' desire tocarry inventories (think of oil inventories held in tanks); by encouraging speculators to shift out of spotcommodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interestrates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering thecost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during

2001-2004. It's the original "carry trade."

To summarize then: low real interest rates are strong (perhaps, one of the primary) movers of commodityprices. Declining real interest rates are, in general, supportive of commodity prices even during the

preliminary stage of a growth recession.

Equities and Real Interest Rates

The historical correlation between REAL interest rates and future equity prices is well documented withan abundance of existing studies to support the correlation (e.g., Nissim, Penman, 2003). A trend of lower

real rates tends to be conducive to higher equity prices and vice versa. This is also true for commodities aswe have shown in earlier paragraphs.

This concept is based on the generally accepted principle that interest bearing securities are the primarysource of competition for equity investment dollars. Higher expected returns for one investment, reducesthe appeal of its primary alternative. Also, the cost of borrowing money has an influence on the expenseof doing business for many companies, such as banks and utilities. The expectation of any changes infuture earnings is a primary driving force in determining the appeal of equities.

In theory, this accepted relationship would always hold true, if all other market forces were held constant.But since rate changes can be symptomatic of other underlying factors that impact the direction of equityearnings, it begs the question, When does the basic interest rate to equity relationship not apply? And in

regard to the current market, What should one expect for the equity markets when rates stay low fromthe current already extremely low levels?


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For example, we have strong historical evidence of the negative impact that deflation (which isaccompanied by a collapse in interest rates) has on equity markets. We have the 1930s depression era asour primary data point, and even as recently as the last decade, we watched the Federal Reserve lowerrates to near zero in both 2001 and 2008, long before stocks were able to eventually find a bottom andreverse course. If we accept that rates very low and declining are often symptomatic of a deflationaryscenario and not necessarily bullish for stocks, then doesnt it beg the question that rates very low and

staying low for long might even be more bearish for equity prices? And especially so, if the fall inalready low rates indicates a move from disinflation to deflation and will push equity prices even lower?(See chart below).

Wayne Whaley (2009) found that the level of interest rates has some modest impact on the direction ofequity prices, but is not nearly as significant as the direction of interest rates. As a general rule, a trend oflower interest rates leads to substantially higher equity prices and higher rates leads to muted andsometimes negative performance. However, the study data suggest that even if interest rates are extremelylow (which can often coincide with recessionary or deflationary scenarios), signs of further economicdecline is usually received badly by the equity markets, even if it is accompanied by falling interest rates.

As for additional data on low rates and declining regimes, Whaley (2009) showed that at the close of1928, the 10 year note was 3.58 and declined steadily throughout the next decade to a low of 1.97% at theend of 1940. During that same period of declining rates, the S&P lost 54.5%.

When rates are extremely low, the beneficial impact accruing from further decline in rates appear to be

suspect in most cases the negative correlation between equity prices and real interest rate does notnecessarily hold anymore.

For our part, we expect that the most ominous interest rate scenario for equities would be a situationwhere short term rates stay near the current rates of zero (as the Federal Reserve has promised), and longterm rates confirm the Feds deflationary concerns by contracting from 4% levels to below 3% as theprospects for economic growth diminishes and the odds of deflation increases -- which is what happenedin recent weeks. Recall that during the 2008 crisis, 30 yr bond yields got to as low as 2.55% and stocksstill got hammered in the process.

To summarize then: A trend of lower real rates tends to be conducive to higher equity prices and viceversa. But when rates are very low and declining -- often symptomatic of a deflationary scenario or the

preliminary stage of a recession -- equity prices generally contract further, even if interest rates fallfurther. That is why the current environment is not bullish for equities at all.


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Varying Responses of Equities and Commodities to Emergence from Negative Rates

Kahneman and Tversky (Prospect Theory: An Analysis of Decision under Risk, 1979) showed that thecategory boundary between certainty and uncertainty is what matters most to an investor. Their researchwas devoted to the investigation of apparent anomalies and contradictions in human behavior. Inexperiments, subjects when offered a choice formulated in one way might display risk-aversion but when

offered essentially the same choice formulated in a different way, they might display risk-seekingbehavior. Other experiments also showed that people's attitudes toward risks concerning gains may bequite different from their attitudes toward risks concerning losses.

Extending those concepts, Kahneman and Tversky made the assertion that in the absence of a truly risk-free asset that preserves purchasing power, the very idea of a 'risk premium' is meaningless." This bringsus to the philosophical underpinnings of QE2 and the recent statement from the FOMC that Fed fundsrate will be kept low (0.25 to 0%) until mid-2013. The policy basically drove a stake through the heart ofmoney demand, and is clearly an attempt to encourage investors to move up the risk curve. The Fedbelieves (or Mr. Ben Bernanke, at least, believes) that by removing the risk premium associated withunexpected raising of (real) interest rates, investors will be encouraged to move from "safe" but lowyielding assets to higher yielding (but inherently more risky assets), to help the economy move along.Bernanke and the FOMC have formulated a policy which may create a truly risk-free asset, but itremains to be seen whether or not that asset will met the second Kahneman-Tversky condition ofpreserving its purchasing power.

The monetary policy has an outsized impact on asset prices is accepted as a given in the markets and inthe Fed. In a speech in 2003, Ben Bernanke concluded that easy money policies increase asset pricesprimarily via a reduction in risk premiums: The most powerful effect of an unanticipated monetarytightening is to increase the perceived risk premium on stocks, either by increasing the riskiness of stocks,by reducing peoples willingness to bear risk, or both. Reduced willingness of investors to hold relativelymore risky stocks drives down stock prices. In the same speech, Bernanke concludes that the changes inthe expected evolution of real rates from changes in the Fed Funds rate are minimal. This conclusion did

not hold for programs such as QE2 which directly attempted to drive down the level of the real rate curve.

As can be deduced from our discourse on real rates vs. commodities and equities in previous sections, ourconjecture follows this course: as the real rate curve turns negative, there is a non-linear transition in therisk premium for all risky assets towards a level close to zero. Risk premiums may never be exactlyzero even under the most dovish monetary regime -- the market expects real rates to turn positive atsome time in the future. Even the effective risk premium in a market that expects sustained negative realrates for, say, two years, may not be far above zero -- but not zero nonetheless. The non-linearcharacteristic of that transition makes a categorical description of market evolution hard to predict, but wecan say with certainty that unexpected developments (like lower prices) can easily be the most likelyoutcomes. That projection can hold true for both equities and commodities, but our experience shows thatcommodities have almost always come out performing better than equities during those transition periods.

The most important takeaway from these statements is that commodities have a clear niche to fill in theinvestment universe. Under certain special conditions when real interest rates are low or are negative,commodities had almost always outperformed equities. When conditions deteriorate some more and ratesdecline further from already very low rates, and those conditions sustained for long, then theoutperformance of commodities over equities is stellar (see chart next page).

To summarize then: a consequence of a pronounced negative real rates regime is that a transition intohigher-rate regime will have much more violent negative consequences for risky asset prices. However,

this is where the equity-commodity divide will become even starker. A rise from super-low real rates will

impact equities in a negative way, while its corresponding impact on commodity prices will be at least

neutral or in the net, positive, as inflationary fears will require inflation hedge measures -- which

commodities can admirably provide (as stand-alone or as a significant part of an equity-commoditiesportfolio).


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DCI vs. S&P 500 and Euro Stoxx 50 Total Return

0

100

200

300

400

500

600

700

800

900

1000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

DCI outperforms S&P 500 Tot Return

DCI underperforms S&P 500 Tot Return

DCI outperforms Euro Stoxx 50 Tot Return

DCI underperforms Euro Stoxx 50 Tot Return

Source: Diapason

6 months

6 months

5 months

That was then; this is now

Since interest rates and inflation respond differently (even conversely) to changes in monetary supply,arguably, the most powerful indicator of liquidity is Fed policy intent and the tools the central bank use toput its policy into effect. We have all heard the saying don't fight the Fed; while many market sayingsare clich this one carries weight -- a heavy one. The impact of the Fed's monetary policy coming out ofthe Great Recession of 2007-2008 was enormous, and was the biggest single determinant of asset pricesin the short and medium-term since the start of the 2009 recovery.

In addition to its zero-interest rate (ZIRP) policy, the Fed's QE1 and QE2 quantitative easing programsinjected massive amounts of liquidity into the economy in an effort to "prime the pump" and get peoplespending. Unfortunately there is little evidence that the injected liquidity has found its way to Main Street.Instead evidence shows it has gone into financial markets and in the process has helped inflate assetprices (primarily commodity prices), which was of extreme importance to Wall Street and the survival ofthe beleaguered global financial sector.

At this point, we can categorically say that the Fed misdiagnosed what ails the economy and overlookedthe prevailing condition of a household balance sheet recession which is preventing growth from takinghold. The collapse of the Great Debt Bubble left the private sector devastated and is left to service bubble-era debts with post-bubble era incomes. This forced former big spenders turn into savers hence the

consumer/service sector which comprises 70% of the U.S. economy became stagnant, and will remain sountil the private sector deleveraging process is completed.

It is now a moot discussion point why the Fed focused primary on the banks with the quantitativeprograms they have undertaken at the outset. Regardless, the collective quantitative easing effort did the job fairly well --- the large banks survived, in a fashion and more so, considering that it was the firsttime that the Great Experiment was done in the U.S. However, the rescue of the banks (who were thepurveyors of the toxic financial cocktail which brought on the Great Recession) depleted the politicalcapital of the Fed, and so the central bank will go into another potential round of GE later this week withlessened stature.


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Asset Class Performance during QE1 (base 100)

60

70

80

90

100

110

120

130

140

150

Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10

SP 500 Total Return Euro Stoxx 50 Total Return

Barcap Bond Composite Global Index USD vs EUR

DCI Total Return S&P GSCI Ex-Agri Total Return

Nov-08: QE1 announced

Mar-09: QE1 starts

Mar-10: End QE1

Feb-09: QE1 expanded

Source: Diapason

Asset Class Performance since the end of QE1and before QE2 (base 100)

80

85

90

95

100

105

110

115

Mar-10 Apr-10 May-10 Jun-10 Jul-10




Aug-10: Hints of QE2

Source: Diapason

Asset Class Performance during QE2 (base 100)

80

90

100

110

120

130

140

150

A ug -10 Sep -10 O ct -1 0 N ov- 10 D ec- 10 J an -11 F eb- 11 Ma r- 11 A pr -1 1 May -1 1 J un -1 1




Source: Diapason

Aug-10: Hints of QE2

Nov-10: QE2 starts

Jun-11: End QE2

Asset Class Performance since end of QE2 (base 100)

75

80

85

90

95

100

105

110

3 0- Ju n- 11 0 7- Ju l- 11 1 4- Ju l- 11 2 1- Ju l-1 1 2 8- Ju l- 11 0 4- Au g- 11 1 1- Au g- 11 1 8- Au g- 11




Source: Diapason

June-2011: End QE2

At this late stage, there is no denying that without QE1 and QE2, asset prices (equities, commodities,bonds, and precious metals) would be a lot lower than they are today. The evidence for this claim is verycompelling -- and to us, it really drives home the message that it is risky, even dangerous, fighting theFed. The bond market knows this very well; as commodity managers this is also beyond faith for us.

The Federal Reserve's tool in injecting liquidity to the financial system is the NY Fed's Permanent OpenMarket Operations (POMO). Recent history shows that whenever the POMO is actively buying or notbuying securities, asset prices have gone up or down. Examples abound: from mid 2005-2007 the Fedwas buying small quantities and the market, already in an uptrend, continued higher with muted volatility.Later during the early stages of the crisis, and after the Bear Stearns breakdown, the Fed decided in all its

wisdom to sell some of its securities, taking liquidity out of the market at the exact time that they shouldhave been adding it. While it was not the cause of the crash, it did further enable it.


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As the mid-2010 correction got going and with the backdrop of high unemployment and a still sluggisheconomy, the Fed embarked on QE2. As you can see, the market once again moved significantly higherthereafter. The second round of quantitative easing was distinct from the first and more akin to what theJapanese had done. The aim was to support economic activity in the US domestic economy. Starting inAugust 2010, the Federal Reserve started reinvesting principal payments from agency debt and agencymortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities.

By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by$600 billion through the purchase of Treasury securities. After QE2 ended in June 2011, and the Fed

stopped buying securities, the markets again consolidated, with the equity markets moving down 18% inless than three weeks. It is also interesting to note that commodity markets, the direct beneficiary of allthat surfeit liquidity, started a price correction right after the rollout of QE2 ended in June.

All of these bring us to the current dire situation of riskier asset prices (equities, commodities). The Fedlast week announced that it will maintain a ZIRP until at least mid-2013 in response to a recent spate ofsurprisingly bad economic news. Speculation is now rife that the Fed will embark on another quantitativeeasing program, a QE3 if you will. There is intense debate on the necessity, even usefulness, of anotherquantitative easing move, on top of the extended ZIRP program. Nonetheless, the Fed's policy scope witha ZIRP set until mid-2013 is the more ambitious and transparent done by any central bank so far -- even ifno further augmentations to the program are announced at Jackson Hole on August 26.

The promise of two years or more of super-low funding costs will almost certainly galvanize the bankingindustry and the institutional investment community. Banks stand to make handsome profits with anoutsized and semi-permanent gap between their funding costs and their loan portfolio, and they can evenmake hay by buying Treasury notes and bonds, since the Fed is basically guaranteeing that the yield curvewill be positively sloped for at least two years. Institutional investors can borrow at rates only slightlyhigher than the funds rate, and use the proceeds to leverage themselves into a variety of attractivesituations anything that promises to yield more than 1% or so.

Given recent assurances from the Fed, low, even negative, interest rates are here to stay for some time, so

there will be opportunities which will leverage those conditions to the maximum. One natural trade which

will take advantage of such conditions is the outperformance of commodities over equities, specifically

under these circumstances.


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A very good example of that leverage can be seen during the period August 2002 to October 2005 whenreal interest rates declined and have gone as low as -2.0% by May 2004. By the time this hypotheticaltrade was wound down, commodities have outperformed equities by around 70%. The DCI Total Returnscompounded annual growth rate of 33.1% outstripped the S&P 500 Total Returns 11.2% CAGR. (Seecharts below).

Equities, Commodities and Real Interest Rate 2000-2011

0

100

200

300

400

500

600

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

J

an-2000=100

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

S&P 500 Total Return (lhs) Euro Stoxx 50 Total Return (lhs)

DCI Total Return (lhs) S&P GSCI Ex-Agri Total Return (lhs)

Real Interest Rate (Inverted, rhs)

Sources: Diapason, Fed Reserve

To summarize then: there will be less hoarding of money, more risk-taking, and more lending andborrowing henceforth. But will the money be directed to productive, job-producing activities, or just to

consumption and speculative activities? That issue is not quantifiable at this point. But given the dire

state where asset prices are at this juncture -- it may not matter much at this time. Sooner or later we

should see faster growth in the money supply, a weaker dollar, much stronger commodity prices, higher

real estate prices, higher stock prices, and of course higher inflation at some point. Low real rates,

even negative rates, will also provide opportunities to leverage the time-proven capability of commodities

to outperform equities under these financial conditions. Whether or not we will see a stronger economy is

another issue.

S&P and CRB Index and Real Interest Rate 1970-1981

0

50

100

150

200

250

300

350

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981

Jan1970=100

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

S&P Comp. (Including Dividend) y/y (lhs)

CRB Index y/y (lhs)

Real Interest Rate (Inverted, rhs) Sources: Diapason, Fed Reserve


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(6) Lowering the 0.25% interest rate the Fed pays on bank reserves: The argument for lowering the0.25% interest rate the Fed pays on excess reserves (IOER) is that such a move will promote more banklending. The thinking is that banks have limited incentives to make loans when they can earn a risk-freereturn on reserve balances maintained at the Fed. Consequences: little to no adverse consequence onstocks and commodities, but will wreak havoc on money markets. Because of extremely high excessreserves, banks have no need to borrow required reserves in the fed funds market. Hence, the fed funds

rate is no longer the marginal funding cost of the loans. The marginal cost of bank lending has gone equalto the IOER. Zero IOER sets off a lot of consequences, the most onerous of which is the possibility thatdeposit rates could fall below 0%, which then cascades into repos and bills that would make operating amoney market fund impossible. Chances of happening: low-medium.

(7) Operation Twist: In the 1960s the Fed deployed a program known as Operation Twist. Underthis program, the Fed manipulated longer-term interest rates lower, while allowing short-term interestrates to rise. A second Operation Twist may do much of the same. Consequences: A twist can help theeconomy by bringing down interest rates on key consumer purchases. But it may completely eliminate theFeds ability to manage its balance sheet. If the Fed commits to capping rates on particular notes (say, 10years), it may theoretically have to expand its balance sheet at a practically endless rate. This canmoderately weaken the dollar and moderately boost riskier assets for a lengthy period of time. Chances ofhappening: high - this is a small policy change that could provide some relief but is not too radical orwild.

(8) Go toabsolute 0% rate: Pushing rates to 0% would supply more liquidity, but liquidity is not theproblem. The problem is that everyone is deleveraging, and the banks don't want to lend out money.Consequences: the effect on the dollar will be positive (because of no QE). Chances of happening: small.

(9) Targeting Nominal GDP: This means that the Fed wants serious GDP growth, regardless ofinflation. In other words, allowing higher inflation to erode debt, perhaps up to 5%. This is a bold changeof course from the past 30 years. Inflation can help in erasing debt and also ignite real growth, but canalso get out of control. Consequences: The dollar will weaken in this case. Chances of happening: low.

(10) Nothing at all: Bernanke can just speak about the sorry state of the economy, saying that all theappropriate tools are in place for now, and that he expects recovery later on. A non-event from Bernankedoes not mean it is a non-event for the markets. Consequences: stock markets will crash due to QE3anticipation, and the dollar will rise on no new dollar printing. Chances of happening: low-medium, givenrising deflation and growing opposition within the bank and also from politicians, but countered by Mr.Bernankes commitment to prevent deflation from taking hold in the U.S.

To summarize then: the above survey shows that the universe of likely (medium to high) QE3 alternativesor possibilities show that the Feds choices going into the Jackson Hole speech on August 26 are not

binary (on-off, either-or). Mr. Bernanke may choose one primary tool in conjunction with others, or even

most of the options outlined above. We do not believe that the Fed chairman will elect to do nothing in the

light of alarming sentiment surveys and failing manufacturing data that have been reported of late. Givenhis perceived character and career-long expertise as a Great Depression expert, Mr. Bernanke will likely

choose creative and innovative ways to kick-start the economy once again. Therefore, we expect the

outperformance of commodities over equities to continue throughout the rest of the year.


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Looking Beyond Quantitative Easing and Negative Real Interest Rate Regimes

Since records of equity and commodity prices started to be kept in the mid-1800s, a clear cyclical patternhas emerged in the correlation between equities and commodities there are some periods when paperassets were preferred. And there also clear indications of subsequent periods when commodities gainedthe upper hand (see chart below).

The first cycle in the chart shows that after a post-civil war reconstruction boom in the U.S. ended andgold standard was introduced, a disinflationary boom started, providing the wherewithal for stocks to risesignificantly, outperforming commodities. The boom lasted well into the early 1900s, and was cut shortby the Panic of 1907 which was characterized by a banking crisis and a sharp stock market crash. A fewyears later, World War 1 started (1914), pushing the supply of basic resources to the limit, causing sharpgains in commodity prices. The commodity outperformance lasted well into the 1920s, when thecommodity bubble burst after WW 1 ended, followed by a severe disinflation.

From that point on, equity outperformance made a strong comeback, paper assets regained their allure,which came to a peak in 1929. The stock market crash of 1929 signalled the beginning of a commoditiesoutperformance, after paper assets got out of vogue as a consequence of the stock market crash. Thedominance of paper assets returned several times following the crash, e.g., after gold was nationalized,and after Franklin Delano Roosevelts New Deal kick-started a reflation process. But WW II needsagain pushed commodity prices higher, reasserting the commodities outperformance over equities at thattime. After the war ended in 1946, the post WW II commodity and inflation bubble burst in the early1950s. Disinflation ensues, the veterans came home, the baby boomers were born, and the Eisenhowerequity bull market began the equity outperformance lasted well into the late 1960s.

Lyndon B. Johnson launched both the Great Society program and the Vietnam War in the early 1960s,and war requirements again re-awakened a commodities outperformance. Richard Nixon closed the goldwindow in 1971, severing the dollars convertibility to gold. Both events were highly inflationary,provoking a run for hard assets. OPEC also formed and implemented the 1973 Oil Embargo, setting off aglobal recession. The Shah of Iran also fell in 1979, ushering in the reign of the ayatollahs, and further

rise in crude oil prices.


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However, the OPEC overplayed its hand in 1981 after a global recession collapsed crude oil prices. FedChairman Paul Volcker also stopped U.S. inflation on its tracks in 1981 1982 by raising short term ratesto as high as 22%. Then President Ronald Reagan cut taxes and engineered the collapse of the SovietUnion. Once again, paper assets regained prominence with a stock market bull run, as a sharp and longdisinflation process began.

The dominance of equities came to a screeching halt in 2000 after the tech bubble collapsed. The U.S.Dollar started its long slide, and the current commodity bull market began. This cycle is still playing out,and commodity over equity dominance will likely be the base case scenario for a few more years.Regardless of the outlook for real interest rates, a new long-term economic actor may soon enter thetheatre INFLATION (sooner if U.S. monetary and fiscal authorities arrive at a sound diagnosis of whatails the economy; much later, if they dont).

The periods of commodity outperformance over equity have ranged anywhere from 15 to 22 years

in previous cycles we expect the cycle period to be sustained once again. We likely have anywherefrom 6 to 9 more years of hard assets dominance over paper assets. A revival of global inflationary

pressures, which could manifest after several quarters, will likely signal a resurgence of the ongoing

commodities outperformance over equities in the coming years.

CONCLUSION

The early part of this essay dealt with the individual performances of commodities and equities withregards to varying regimes of real interest rates. To summarize:

A. Low real interest rates are strong (perhaps, one of the primary) movers of commodity prices.Declining real interest rates are, in general, supportive of commodity prices even during the

preliminary stage of a growth recession.

B. A trend of lower real rates tends to be conducive to higher equity prices and vice versa. Butwhen rates are very low and declining -- often symptomatic of a deflationary scenario or thepreliminary stage of a recession -- equity prices generally contract further, even if interestrates fall further.

C. A consequence of a pronounced negative real rates regime is that a transition into higher-rateregime will have much more violent negative consequences for risky asset prices. However,this is where the equity-commodity divide will become even starker. A rise from super-lowreal rates will impact equities in a negative way, while its corresponding impact oncommodity prices will be at least neutral or in the net, positive, as inflationary fears willrequire inflation hedge measures -- which commodities can admirably provide (as stand-aloneor as a significant part of an equity-commodities portfolio).

D. To put it simply: under special conditions when real interest rates are low or are negative,commodities almost always outperform equities. When conditions deteriorate some more andrates decline further from already very low rates, then the outperformance of commoditiesover equities is stellar.

The above findings then suggests possible courses of action with regards to diversification (or non-diversification) of market risk. The ultimate arbiter of which diversification course to follow is the stagethe business cycle is in (which characterizes the trend of inflation), and which, in turn, determines Fed

policy action. Monetary policy, in turn, impacts both inflation expectations, level of interest rates andeven the subsequent rate of GDP growth -- in a sense bringing the loop to a full circle.


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It is also contingent to understand the impact of the business/monetary policy cycle on individualcomponents of a commodity index. For example, precious metals, base metals, and energy respond moreto changes in monetary policy and economic conditions. On the other hand, livestock and agriculturalcommodities are heavily influenced by the level of the U.S. Dollar (itself a creature of interest rate levels)and of course by weather conditions and unanticipated seasonal factors.

Nonetheless, we can probably distil the basic principles of using commodities as a diversification tool oreven as a means of augmenting beta in the following manner:

1) Commodities should be added to the portfolio or commodities allocations are increased wheninterest rates are very low, and will stay that way for very long, or have the tendency to go evenlower

2) Commodities should be added to the portfolio or commodities allocations are increased wheninflation or rising interest rates are a primary concern (or when the Fed starts to take a morerestrictive policy stance).

3) If the portfolio construction allows it, a commodity tactical allocation strategy should be

deployed. It should be predicated on monetary conditions as policy changes impact various typesof contracts in different ways. During periods of restrictive monetary policy (signifying inflationpressures), energy and agricultural products will likely provide larger returns. On the other hand,livestock and agriculture have superior performance during expansive policy periods. Thismanner of weighting could also further enhance beta and can be rightfully called "alpha".

As an inflation protection tool, commodities excel. The performance scale has to be calibrated, however.Coming out of low-inflation environment, both commodities and equities benefit from the reflationprocess. It is at the middle of the reflation cycle when commodities start to outshine equities. The reasonsare simple: it is usually at this point that inflation expectations are well-developed, and actual inflationbecomes an issue. The outperformance of commodities extends beyond the peak of the inflation cycle. Itis close to the middle of the inflation downcycle when commodity outperformance starts to wane, andequities take over the lead.

S&P Composite / CCI 1956-2011

10

100

1000

10000

1 95 6 1 95 9 1 96 2 1 96 5 19 68 1 97 1 19 74 1 97 7 1 98 0 1 98 3 1 98 6 19 89 1 99 2 19 95 1 99 8 20 01 2 00 4 2 00 7 2 010

LogScale

S&P Composite Tot Return / CCI Tot Return (Log scale)

Source: Diapason


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Supporting Graphs:

- Correlation between DCI and Equities

The implementation of QE1 and QE2 led to a decrease of the correlation betweencommodities and equities. The correlation between commodities and equitiesincreased at the end of QE1 and fell three months after the start of QE2.

- DCI vs MSCI EM and Real Interest Rate

DCI vs MSCI EM and Real Interest Rate

70

90

110

130

150

170

190

210

230

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

DCI / MSCI EM Total Return (lhs)


3-Month Rolling Correlation with DCI

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

DCI Correlation With S&P 500

DCI Correlation With MSCI WorldDCI Correlation With DJ EURO STOXX 50

QE1 announced

QE1 starts

QE1 ends

QE2 starts

QE2 ends

Source: Diapason

QE2 Announced


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- DCI vs MSCI EM Asia and Real Interest Rate

DCI vs MSCI EM Asia and Real Interest Rate

80

90

100

110

120

130

140

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

DCI / MSCI EM Asia Gross Return (lhs)


Sources: Diapason, Bloomberg

- Oil Price and Real Interest Rate

Oil Price and Real Interest Rate 2006-2011

-80

-60

-40

-20

-

20

40

60

80

2006 2007 2008 2009 2010 2011

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

WTI Oil Price 12M Actual Change (lhs)

Real Interest Rate 12M Actual Change (Inverted, rhs)Real Interest Rate (Inverted, rhs)



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- Gold Price and Real Interest Rate

Gold Price and Real Interest Rate 2006-2011

-450

-375

-300

-225

-150

-75

-

75

150

225

300

375

450

2006 2007 2008 2009 2010 2011

DollarsperOunce

-8%

-4%

0%

4%

8%

Gold, Comex 12M Actual Change (lhs)Real Interest Rate 12M Actual Change (Inverted, rhs)Real Interest Rate (Inverted, rhs)


- Copper Price and Real Interest Rate

Copper Price and Real Interest Rate

-7'500

-6'000

-4'500

-3'000

-1'500

-

1'500

3'000

4'500

6'000

7'500

2006 2007 2008 2009 2010 2011

DollarsperMetricTons

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

LME Copper Cash 12M Actual Change (lhs)


Real Interest Rate 12M Actual Change (Inverted, rhs)



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REFERENCES:

Daniel Kahneman, Amos Tversky: Prospect Theory: An Analysis of Decision Under Risk;Econometrica (March 1979)

Doron Nissim, Stephen H. Penman: The Association between Changes in Interest Rates,Earnings, and Equity Values; Contemporary Accounting Research (Winter2003)

Ashwin (blog): Negative Real Interest Rates and the Risk Premium, Macroeconomic Resiliencewebsite: http://www.macroresilience.com

Gerald Jensen, Jeffrey M. Mercer: Tactical Asset Allocation and Commodity Futures,NorthernIllinois University, DeKalb, IL

C. Mitchell Conover, Gerald R. Jensen, Robert R. Johnson: Is Now the Time to AddCommodities to Your Portfolio? Journal of Investing (December 2009)

Ever B. Vrugt, Rob Bauer, Roderik Molenaar: Dynamic Commodity Timing Strategies (July2004),ABP Investments Amsterdam, Netherlands

Gary Norton, K. Geert Rouwenhorst: Facts And Fantasies about Commodity Futures, NBERand Yale University, February 28, 2005

Jeffrey Frankel: The Effect of Monetary Policy on Real Commodity Prices; Asset Prices andMonetary Policy (NBER), November 2006

Henry H. McVey: Commodities: Friend or Foe? Investment Focus, February 2010 issue

Claude B. Erb, Campbell R. Harvey: The Tactical and Strategic Value of Commodity Futures,Trust Company of the West (LA, CA) and Duke University (January 2006)

Van Thi Tuong Nguyen, Piet Sercu: Tactical Asset Allocation with Commodity Futures:Implications of Business Cycle and Monetary Policy, November 2010

James Chong, Joelle Miffre: Conditional Returns Correlations between Commodity Futures andTraditional Assets,EDHEC Risk and Management Research Centre, April 2008

Cullen Roche: This is a Balance Sheet Recession And Its Likely to Persist, Seeking Alpha,

August 14, 2011

Nik Bienkowski: Commodities Outperform During Equity Market Downturns, Seeking Alpha,March 16, 2007

Scott Grannis: The Real Meaning of Yesterdays FOMC Announcement, Seeking Alpha, August10, 2011

James A. Kostohryz: Read Bernankes Lips: No Depression, No Deflation, Seeking Alpha,August 22, 2011

Yohay Elam: Hole in Jackson Hole? 7 Scenarios for Bernankes Speech, Seeking Alpha, August23, 2011


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DISCLAIMER

General Disclosure

This document or the information contained in does not constitute, an offer, or a solicitation, or

a recommendation to purchase or sell any investment instruments, to effect any transactions, or

to conclude any legal act of any kind whatsoever. The information contained in this document is

issued for information only. An offer can be made only by the approved offering memorandum.

The investments described herein are not publicly distributed. This document is confidential and

submitted to selected recipients only. It may not be reproduced nor passed to non-qualifying

persons or to a non professional audience. For distribution purposes in the USA, this document

is only intended for persons who can be defined as Major Institutional Investors under U.S.

regulations. Any U.S. person receiving this report and wishing to effect a transaction in any

security discussed herein, must do so through a U.S. registered broker dealer. The investment

described herein carries substantial risks and potential investors should have the requisiteknowledge and experience to assess the characteristics and risks associated therewith.

Accordingly, they are deemed to understand and accept the terms, conditions and risks

associated therewith and are deemed to act for their own account, to have made their own

independent decision and to declare that such transaction is appropriate or proper for them,

based upon their own judgment and upon advice from such advisers as they have deemed

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(Diapason) disclaims all liability to any party for all expenses, lost profits or indirect,

punitive, special or consequential damages or losses, which may be incurred as a result of the

information being inaccurate or incomplete in any way, and for any reason. Diapason, its

directors, officers and employees may have or have had interests or long or short positions in

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Certain statements in this presentation constitute forward-looking statements. These

statements contain the words anticipate, believe, intend, estimate, expect and

words of similar meaning. Such forward-looking statements are subject to known and unknown

risks, uncertainties and assumptions that may cause actual results to differ materially from the

ones expressed or implied by such forward-looking statements. These risks, uncertainties and

assumptions include, among other factors, changing business or other market conditions and the

prospects for growth. These and other factors could adversely affect the outcome and financial

effects of the plans and events described herein. Consequently, any prediction of gains is to be

considered with an equally prominent risk of loss. Moreover, past performance or results doesnot necessarily guarantee future performance or results. As a result, you are cautioned not to

place undue reliance on such forward-looking statements.

These forward-looking statements speak only as at the date of this presentation. Diapason

expressly disclaims any obligation or undertaking to disseminate any updates or revisions to any

forward-looking statements contained herein to reflect any change in Diapasons expectations

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the date of the presentation and are subject to change without notice.


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Last update on 9 February 2011.

commodities+and+real+interest+rates final ver3.41 2011.09.01

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