China 10Y Yield vs. Copper Prices

In the past year, we have seen that commodity prices have been constantly reaching new highs despite the significant slowdown in global growth. Part of the slowdown has been coming from the sharp deceleration in Chinese economic activity amid the ‘zero-Covid’ policy that has been strongly weighing on growth expectations. As a result, China ‘fundamental’ indicators, which have historically strongly co-moved with commodity prices, have been significantly diverging from commodity indexes since early 2021 (China indicators show that the economy peaked in February 2021).

For instance, this chart shows that while market uncertainty has kept China 10Y yield close to historical lows, copper prices keep reaching new highs (China represents 50% of the demand for copper).

Two major reasons explaining that divergence are:

  1. Global supply chain disruptions (Covid disruptions, ‘natural disaster’ disruption i.e. South American droughts, and more recently the Ukraine war ‘shock).
  2. Investment narrative, with investors seeking for ‘inflation hedges’ with inflationary pressures soaring globally. Historically, commodities have been the best ‘inflation-hedge’ (particularly oil and nat gas).

Figure 2. China 10Y yield vs. copper prices

Source: Bloomberg

The question now is: can the divergence persist if inflation is peaking and is now expected to slowly but gradually decelerate?

Great Chart: US Term Premium vs. Business Cycles

Academics and economists have often decomposed the long-term bond yield of a specific country (i.e. US 10Y Treasury) into the sum of the expected path of real interest rate (r*) and the additional term premium, which compensate investors for holding interest rate risk. Two major risks that a bond investor typically face in the long-run are the change in supply of and demand for bonds and the uncertainty around inflation expectations. If the uncertainty increases, the market will demand a higher premium as a response. As the premium is not directly observable, it must be estimated using econometric models. For instance, a popular one that practitioners use is the one developed by Adrian, Crump and Moench (2013), who estimated fitted yields and the expected average short-term interest rates for different maturities (1 to 10 years, see data here).

As you can see, the term premium has been falling since 2009 and is currently negative at -51bps, which has not happened very often. Instead of having a positive term premium for long-term US debt holders carrying interest rate risk, there is actually a discount. The term premium for the 10Y reached an all-time low of -84bps in July 2016, at the same time that the yield on the Treasury reached a record low below 1.40%. However, there are also interest findings when we plot the ACM 10Y term premium with macroeconomic variables. If we overlay it with the US unemployment rate, we can notice a significant co-movement between the two times series. The jobless rate went down from 10% in Q3 2009 to 4.1% in March 2018, tracked by the term premium that fall from roughly 2.5% to -50bps in that same period. In other, it seems that the term premium follows the business cycles, trend lower in periods of positive growth and falling unemployment and rises in periods of contractions. Therefore, for those who are expecting a rise in the US LT yields in the medium term, driven by a reversion in the term premium, what does it mean for the unemployment rate going forward?

Chart. US Unemployment Rate vs. 10Y Term Premium

US Term Pr.png

Source: Reuters Eikon and Adrian et al. (2013)