Diapason Commodities Management Special Report August 25, 2011

THE IMPACT OF REAL INTEREST RATES ON THE COMMODITY EQUITY RELATION

Robert Balan and Alessandro Gelli
robert.balan@diapason-cm.com alessandro.gelli@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 and time again. From a virtual poor cousin of the equity and bond markets, commodities have sprung to the forefront as genuine alternative investments after a tumultuous decade in the financial markets radically changed the investments norms in equities and bonds. The investment horizons in these two asset classes have 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 for tactical asset diversification or inflation hedging but now commodities are at the same footing as the other asset classes in its legitimacy as a true investment vehicle. And more than ever, commodities have become 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 were considered pass as late as 2001 (when the commodities market bottomed). Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was then considered behind the times. In Alan Greenspan's phrase, GDP had gotten "lighter;" the economy was becoming weightless, "dematerializing." Agriculture and mining no longer constituted a large share of the U.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 story in 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 the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real 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).

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

DCI Total Return

800 700

600

500 Jan-99 = 100

400

300

200

100

0 1999

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

There is certainly a lot of merit to many of the explanations that have been offered for the rise in the price of 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 inventory fluctuations in regional crude oil hubs: these factors can rightfully account for the short- to medium outlooks in energy prices. Gold has risen sharply after two major equity crashes less than 10 years apart -- investors seek a safe haven for capital and again as the market contemplates the possibility of a third one looming in the near-future. Corn prices have been impacted by American subsidies for biofuel; the same for sugar in Brazil. Agriculture products in South America have been devastated by the vagaries of nature and weather, and the alternating impacts of El Nino and La Nina. There are many other special microeconomic factors that are relevant in other specific sectors. The common denominator in all these (even for commodities that do not have futures classes) is broad steady rise which suggest multiple causes that impinge on all commodity items. It cannot just be a coincidence that all mineral, metal and agricultural prices have risen virtually across the board in cadence or in synchronization. Clearly, a host of developmental, political, natural, and macroeconomic explanation is called 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. The strongest growth has, of course, been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based -- including up to three years ago, 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, and it 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 completely explain some of the notable exceptions seen so far. We cite two periods which diverge from the growth factor rationale, to illustrate the point why we believe there are other powerful forces at work. (See chart below).

First: during the summer of 2007, the U.S. economy started to slow down noticeably, and was about to enter into a recession. Despite talks of decoupling, it is clear that other countries were also slowing down at least to some extent. In its forecast for the following period, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 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 found their second wind over precisely that period -- up some 25% or more since August 2007, by a number of indices. It was a spectacular performance unmatched yet by any asset class under those global growth conditions. (See chart above). Second: in early spring of 2010 (March), the U.S. economy also started to slow after peaking at 3.94% in the first quarter. However, commodity prices continued to rise sharply higher. This time, the talk was about how China and the rest of the Emerging Markets were "priming the pump" so to speak, and regardless 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 the BRICs. Commodities at that period performed their sharpest climb on record -- more than 50% in less than 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 are other factors that can cause powerful spurts in price gains. How then can we explain the phenomenon of commodity prices going up while the economy turns down? One wouldn't want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point, so clearly broad macro forces are at work. The developments of the last three years provided added support for a view Diapason has had for a long time: real interest rates are an important determinant of real commodity prices (see chart on next page). At certain points in the business cycle, the level and direction of real interest rates can drive commodity prices 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 variety of channels: by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled); by decreasing firms' desire to carry inventories (think of oil inventories held in tanks); by encouraging speculators to shift out of spot commodity contracts, and into treasury bills. All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost 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 commodity prices. 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 with an 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 as we have shown in earlier paragraphs. This concept is based on the generally accepted principle that interest bearing securities are the primary source of competition for equity investment dollars. Higher expected returns for one investment, reduces the appeal of its primary alternative. Also, the cost of borrowing money has an influence on the expense of doing business for many companies, such as banks and utilities. The expectation of any changes in future 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 equity earnings, 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 from the current already extremely low levels?

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For example, we have strong historical evidence of the negative impact that deflation (which is accompanied by a collapse in interest rates) has on equity markets. We have the 1930s depression era as our primary data point, and even as recently as the last decade, we watched the Federal Reserve lower rates to near zero in both 2001 and 2008, long before stocks were able to eventually find a bottom and reverse course. If we accept that rates very low and declining are often symptomatic of a deflationary scenario 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 in already 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 of equity prices, but is not nearly as significant as the direction of interest rates. As a general rule, a trend of lower interest rates leads to substantially higher equity prices and higher rates leads to muted and sometimes negative performance. However, the study data suggest that even if interest rates are extremely low (which can often coincide with recessionary or deflationary scenarios), signs of further economic decline 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 of 1928, the 10 year note was 3.58 and declined steadily throughout the next decade to a low of 1.97% at the end 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 not necessarily hold anymore. For our part, we expect that the most ominous interest rate scenario for equities would be a situation where short term rates stay near the current rates of zero (as the Federal Reserve has promised), and long term rates confirm the Feds deflationary concerns by contracting from 4% levels to below 3% as the prospects for economic growth diminishes and the odds of deflation increases -- which is what happened in recent weeks. Recall that during the 2008 crisis, 30 yr bond yields got to as low as 2.55% and stocks still got hammered in the process. To summarize then: A trend of lower real rates tends to be conducive to higher equity prices and vice versa. 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 fall further. 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 the category boundary between certainty and uncertainty is what matters most to an investor. Their research was devoted to the investigation of apparent anomalies and contradictions in human behavior. In experiments, 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-seeking behavior. Other experiments also showed that people's attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. Extending those concepts, Kahneman and Tversky made the assertion that in the absence of a truly riskfree asset that preserves purchasing power, the very idea of a 'risk premium' is meaningless." This brings us to the philosophical underpinnings of QE2 and the recent statement from the FOMC that Fed funds rate will be kept low (0.25 to 0%) until mid-2013. The policy basically drove a stake through the heart of money demand, and is clearly an attempt to encourage investors to move up the risk curve. The Fed believes (or Mr. Ben Bernanke, at least, believes) that by removing the risk premium associated with unexpected raising of (real) interest rates, investors will be encouraged to move from "safe" but low yielding 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 it remains to be seen whether or not that asset will met the second Kahneman-Tversky condition of preserving its purchasing power. The monetary policy has an outsized impact on asset prices is accepted as a given in the markets and in the Fed. In a speech in 2003, Ben Bernanke concluded that easy money policies increase asset prices primarily via a reduction in risk premiums: The most powerful effect of an unanticipated monetary tightening 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 relatively more risky stocks drives down stock prices. In the same speech, Bernanke concludes that the changes in the 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, our conjecture follows this course: as the real rate curve turns negative, there is a non-linear transition in the risk premium for all risky assets towards a level close to zero. Risk premiums may never be exactly zero even under the most dovish monetary regime -- the market expects real rates to turn positive at some time in the future. Even the effective risk premium in a market that expects sustained negative real rates for, say, two years, may not be far above zero -- but not zero nonetheless. The non-linear characteristic of that transition makes a categorical description of market evolution hard to predict, but we can say with certainty that unexpected developments (like lower prices) can easily be the most likely outcomes. That projection can hold true for both equities and commodities, but our experience shows that commodities 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 the investment 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 rates decline further from already very low rates, and those conditions sustained for long, then the outperformance 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 into higher-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-commodities portfolio).

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

1000 900 800 700 600 6 months 500 6 months 400 300 200 100

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

5 months

Source: Diapason
0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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 to put its policy into effect. We have all heard the saying don't fight the Fed; while many market sayings are clich this one carries weight -- a heavy one. The impact of the Fed's monetary policy coming out of the Great Recession of 2007-2008 was enormous, and was the biggest single determinant of asset prices in 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 programs injected massive amounts of liquidity into the economy in an effort to "prime the pump" and get people spending. 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 asset prices (primarily commodity prices), which was of extreme importance to Wall Street and the survival of the beleaguered global financial sector. At this point, we can categorically say that the Fed misdiagnosed what ails the economy and overlooked the prevailing condition of a household balance sheet recession which is preventing growth from taking hold. The collapse of the Great Debt Bubble left the private sector devastated and is left to service bubbleera 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 so until the private sector deleveraging process is completed. It is now a moot discussion point why the Fed focused primary on the banks with the quantitative programs 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 first time that the Great Experiment was done in the U.S. However, the rescue of the banks (who were the purveyors of the toxic financial cocktail which brought on the Great Recession) depleted the political capital of the Fed, and so the central bank will go into another potential round of GE later this week with lessened stature.

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Asset Class Performance during QE1 (base 100)

SP 500 Total Return Barcap Bond Composite Global Index DCI Total Return
150 140

Euro Stoxx 50 Total Return USD vs EUR S&P GSCI Ex-Agri Total Return

Asset Class Performance since the end of QE1 and before QE2 (base 100)
SP 500 Total Return Barcap Bond Composite Global Index DCI Total Return
115

Euro Stoxx 50 Total Return USD vs EUR S&P GSCI Ex-Agri Total Return Aug-10: Hints of QE2

Mar-10: End QE1 Nov-08: QE1 announced Feb-09: QE1 expanded Mar-09: QE1 starts

130 120 110 100

110 105 100 95

90 90 80 70 85

Source: Diapason
60 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10

80 Mar-10

Source: Diapason
Apr-10 May-10 Jun-10 Jul-10

Asset Class Performance during QE2 (base 100)

SP 500 Total Return Barcap Bond Composite Global Index DCI Total Return
150 140 Aug-10: Hints of QE2

Asset Class Performance since end of QE2 (base 100)

SP 500 Total Return Barcap Bond Composite Global Index DCI Total Return
110

Euro Stoxx 50 Total Return USD vs EUR S&P GSCI Ex-Agri Total Return

Euro Stoxx 50 Total Return USD vs EUR S&P GSCI Ex-Agri Total Return

105

130

100

120

95

110

90

June-2011: End QE2

100
85

Jun-11: End QE2

90
80

80 Aug-10

Source: Diapason
Sep-10 Oct-10

Nov-10: QE2 starts

Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11

Source: Diapason
75 30-Jun-11 07-Jul-11 14-Jul-11 21-Jul-11 28-Jul-11 04-Aug-11 11-Aug-11 18-Aug-11

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 very compelling -- and to us, it really drives home the message that it is risky, even dangerous, fighting the Fed. 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 Open Market Operations (POMO). Recent history shows that whenever the POMO is actively buying or not buying securities, asset prices have gone up or down. Examples abound: from mid 2005-2007 the Fed was 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 should have 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 sluggish economy, the Fed embarked on QE2. As you can see, the market once again moved significantly higher thereafter. The second round of quantitative easing was distinct from the first and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-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% in less than three weeks. It is also interesting to note that commodity markets, the direct beneficiary of all that 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 Fed last week announced that it will maintain a ZIRP until at least mid-2013 in response to a recent spate of surprisingly bad economic news. Speculation is now rife that the Fed will embark on another quantitative easing program, a QE3 if you will. There is intense debate on the necessity, even usefulness, of another quantitative easing move, on top of the extended ZIRP program. Nonetheless, the Fed's policy scope with a ZIRP set until mid-2013 is the more ambitious and transparent done by any central bank so far -- even if no 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 banking industry and the institutional investment community. Banks stand to make handsome profits with an outsized and semi-permanent gap between their funding costs and their loan portfolio, and they can even make hay by buying Treasury notes and bonds, since the Fed is basically guaranteeing that the yield curve will be positively sloped for at least two years. Institutional investors can borrow at rates only slightly higher than the funds rate, and use the proceeds to leverage themselves into a variety of attractive situations 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 when real interest rates declined and have gone as low as -2.0% by May 2004. By the time this hypothetical trade was wound down, commodities have outperformed equities by around 70%. The DCI Total Returns compounded annual growth rate of 33.1% outstripped the S&P 500 Total Returns 11.2% CAGR. (See charts below).
Equities, Commodities and Real Interest Rate 2000-2011
S&P 500 Total Return (lhs) DCI Total Return (lhs) Real Interest Rate (Inverted, rhs)
600

Euro Stoxx 50 Total Return (lhs) S&P GSCI Ex-Agri Total Return (lhs)
-4.0%

Sources: Diapason, Fed Reserve

-3.0% 500 -2.0% 400 Jan-2000 = 100 -1.0%

300

0.0%

1.0% 200 2.0% 100 3.0%

0 2000

4.0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

To summarize then: there will be less hoarding of money, more risk-taking, and more lending and borrowing 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

350 -8.00% 300 -6.00%

-4.00% 250 -2.00% Jan 1970 = 100 200 0.00% 150 2.00% 100 4.00% 50

S&P Comp. (Including Dividend) y/y (lhs) CRB Index y/y (lhs) Real Interest Rate (Inverted, rhs)
1971 1972 1973 1974 1975 1976

6.00%

Sources: Diapason, Fed Reserve

8.00% 1977 1978 1979 1980 1981

0 1970

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A QE3 (or its Analogue) will favour Commodities more than Equities Many economic and political observers are dismissing outright the possibility of the Fed implementing another quantitative easing (QE3) later this week. Most of the arguments expounded dwell on the futility or even the danger or risks presented by further quantitative easing; others point to the diminished stature of the Fed and the potential backlash from Republican Party politicians who call on the central bank to desist from further stimulating the economy via monetary easing. It seems to us that detractors of the central bank do not understand the mandated role the Fed plays under these adverse economic conditions, and moreover, they also do not have any understanding of Ben Bernanke's resolve not to let a Depression happen under his watch. We are hardly at Depression phase (yet), and the current soft patch may be as far as the economic condition goes, if we take Mr. Bernankes own words (Deflation: Making Sure It Doesnt Happen Here, speech given on November 21, 2002 before the National Economists Club, Washington, D.C.). In this speech, he outlined the structural reasons why the chance of deflation in the foreseeable future is small. He also discussed the tools and procedures the Fed can use to prevent deflation from taking root. The speech also underlined his personal commitment that deflation will not happen under his watch. We take that to mean the Bernanke Fed will try to forestall less than acceptable economic conditions from evolving into a critical situation. The Feds action two weeks ago, and Mr. Bernankes highly anticipated rollout of a QE3 (or an analogue) are examples of the ongoing effort to prevent the soft economic conditions from turning into a full-blown recession or worse. So what can the Fed do? (1) Change the FOMC Language: One of the Fed's most effective tool has been modifying the language in the FOMC meeting -- which they have already done two weeks ago when they pledged to keep the fed funds rate low (0 to 0.25%) until mid-2013. Like what we said in earlier reports, the Fed wants to drive a stake through the heart of money demand, and also wants investors to alter their behavior by going up the yield curve in the investment scale. Consequences: it will prove effective in the longer run, but less so in its immediate impact. Expect moderately negative impact to the U.S. Dollar; expect positive impact on riskier assets, especially commodities. (2) Full-scale QE3: Detractors claim that the chances are said to be slim due to inflation uptick and opposition within the Federal Reserve. But some, including us, expect Bernanke to go in this direction in order to calm stock markets and "restore confidence". To deliver shock and awe, the Fed has to commit close to a $1 trillion in new liquidity. Consequences: the dollar will plunge. Riskier assets will soar (commodities the most). Chances of happening: medium. (3) QE3 Limited: James Bullard of the Federal Reserve offered not to commit to long term QE3 plan, but to do it on a meeting by meeting basis. This has small chances, as the Fed prefers to lower the level of uncertainty. Consequences: In this case, the dollar will drop moderately. Riskier assets will also rise moderately. Its a toss-up between equities and commodities. Chances of happening: medium. (4) Extended QE2 Lite: While no new bonds are bought after QE2 ended, maturing assets are reinvested, keeping the balance sheet unchanged -- it is still ongoing. The Fed could pledge to keep it this way and avoid tightening until mid 2013, similar to the pledge around the rates. Consequences: This can moderately weaken the dollar. Chances of happening: medium. (5) Increasing the average maturity of the Fed's holdings: Such a move would not change the size of the Fed's balance sheet but would provide marginally stronger downward pressure on rates out the yield curve and, by extension, on mortgage rates. (This could even amount to an unannounced pegging of longer-term interest rates, say on 10-year notes, as the Fed explicitly managed for about ten years from the early 1940s to the early 1950s.) Consequences: little impact on the dollar, but moderate benefit to equities and commodities. Chances of happening: medium.

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(6) Lowering the 0.25% interest rate the Fed pays on bank reserves: The argument for lowering the 0.25% interest rate the Fed pays on excess reserves (IOER) is that such a move will promote more bank lending. The thinking is that banks have limited incentives to make loans when they can earn a risk-free return on reserve balances maintained at the Fed. Consequences: little to no adverse consequence on stocks and commodities, but will wreak havoc on money markets. Because of extremely high excess reserves, 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 equal to the IOER. Zero IOER sets off a lot of consequences, the most onerous of which is the possibility that deposit rates could fall below 0%, which then cascades into repos and bills that would make operating a money market fund impossible. Chances of happening: low-medium. (7) Operation Twist: In the 1960s the Fed deployed a program known as Operation Twist. Under this program, the Fed manipulated longer-term interest rates lower, while allowing short-term interest rates to rise. A second Operation Twist may do much of the same. Consequences: A twist can help the economy by bringing down interest rates on key consumer purchases. But it may completely eliminate the Feds ability to manage its balance sheet. If the Fed commits to capping rates on particular notes (say, 10 years), it may theoretically have to expand its balance sheet at a practically endless rate. This can moderately weaken the dollar and moderately boost riskier assets for a lengthy period of time. Chances of happening: high - this is a small policy change that could provide some relief but is not too radical or wild. (8) Go to absolute 0% rate: Pushing rates to 0% would supply more liquidity, but liquidity is not the problem. 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 of inflation. In other words, allowing higher inflation to erode debt, perhaps up to 5%. This is a bold change of course from the past 30 years. Inflation can help in erasing debt and also ignite real growth, but can also 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 the appropriate tools are in place for now, and that he expects recovery later on. A non-event from Bernanke does not mean it is a non-event for the markets. Consequences: stock markets will crash due to QE3 anticipation, and the dollar will rise on no new dollar printing. Chances of happening: low-medium, given rising 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 alternatives or 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. Given his 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 pattern has emerged in the correlation between equities and commodities there are some periods when paper assets were preferred. And there also clear indications of subsequent periods when commodities gained the 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 and gold standard was introduced, a disinflationary boom started, providing the wherewithal for stocks to rise significantly, outperforming commodities. The boom lasted well into the early 1900s, and was cut short by the Panic of 1907 which was characterized by a banking crisis and a sharp stock market crash. A few years later, World War 1 started (1914), pushing the supply of basic resources to the limit, causing sharp gains in commodity prices. The commodity outperformance lasted well into the 1920s, when the commodity 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 commodities outperformance, after paper assets got out of vogue as a consequence of the stock market crash. The dominance 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 needs again pushed commodity prices higher, reasserting the commodities outperformance over equities at that time. After the war ended in 1946, the post WW II commodity and inflation bubble burst in the early 1950s. Disinflation ensues, the veterans came home, the baby boomers were born, and the Eisenhower equity 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 gold window 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 a global 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. Fed Chairman Paul Volcker also stopped U.S. inflation on its tracks in 1981 1982 by raising short term rates to as high as 22%. Then President Ronald Reagan cut taxes and engineered the collapse of the Soviet Union. Once again, paper assets regained prominence with a stock market bull run, as a sharp and long disinflation 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 the theatre INFLATION (sooner if U.S. monetary and fiscal authorities arrive at a sound diagnosis of what ails 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 anywhere from 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 with regards 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. 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 fall further. C. A consequence of a pronounced negative real rates regime is that a transition into higher-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-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 and rates decline further from already very low rates, then the outperformance of commodities over equities is stellar. The above findings then suggests possible courses of action with regards to diversification (or nondiversification) of market risk. The ultimate arbiter of which diversification course to follow is the stage the 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 and even 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 individual components of a commodity index. For example, precious metals, base metals, and energy respond more to changes in monetary policy and economic conditions. On the other hand, livestock and agricultural commodities 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 or even as a means of augmenting beta in the following manner: 1) Commodities should be added to the portfolio or commodities allocations are increased when interest rates are very low, and will stay that way for very long, or have the tendency to go even lower 2) Commodities should be added to the portfolio or commodities allocations are increased when inflation or rising interest rates are a primary concern (or when the Fed starts to take a more restrictive 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 types of contracts in different ways. During periods of restrictive monetary policy (signifying inflation pressures), energy and agricultural products will likely provide larger returns. On the other hand, livestock and agriculture have superior performance during expansive policy periods. This manner 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 reflation process. It is at the middle of the reflation cycle when commodities start to outshine equities. The reasons are simple: it is usually at this point that inflation expectations are well-developed, and actual inflation becomes an issue. The outperformance of commodities extends beyond the peak of the inflation cycle. It is close to the middle of the inflation downcycle when commodity outperformance starts to wane, and equities take over the lead.

S&P Composite / CCI 1956-2011

10000

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

1000

Log Scale
100

Source: Diapason
10 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

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Supporting Graphs: Correlation between DCI and Equities

3-Month Rolling Correlation with DCI
1 0.8 0.6 0.4 0.2

QE2 Announced
0 -0.2

QE1 ends QE1 starts

-0.4

QE2 starts QE1 announced QE2 ends DCI Correlation With S&P 500 DCI Correlation With MSCI World DCI Correlation With DJ EURO STOXX 50
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

-0.6 -0.8

Source: Diapason
-1 Jan-07 Jul-07

The implementation of QE1 and QE2 led to a decrease of the correlation between commodities and equities. The correlation between commodities and equities increased 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

230 -5.00% -4.00% -3.00% 190 -2.00% 170 -1.00% 0.00% 1.00% 2.00% 110 3.00% 90 210

150

130

DCI / MSCI EM Total Return (lhs) Real Interest Rate (Inverted, rhs)

4.00% 5.00%

70 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

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DCI vs MSCI EM Asia and Real Interest Rate

DCI vs MSCI EM Asia and Real Interest Rate

140 -5.00%

Sources: Diapason, Bloomberg

-4.00% 130 -3.00% -2.00% 120 -1.00% 110 0.00% 1.00% 100 2.00% 3.00% 90

DCI / MSCI EM Asia Gross Return (lhs) Real Interest Rate (Inverted, rhs)
80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

4.00% 5.00%

Oil Price and Real Interest Rate

80

Oil Price and Real Interest Rate 2006-2011

-8%

60

WTI Oil Price 12M Actual Change (lhs) Real Interest Rate 12M Actual Change (Inverted, rhs) -6% Real Interest Rate (Inverted, rhs)
-4%

40

20

-2%

0%

-20

2%

-40

4%

-60

6%

Sources: Diapason, Fed Reserve

-80 2006 2007 2008 2009 2010 2011 8%

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Gold Price and Real Interest Rate

Gold Price and Real Interest Rate 2006-2011

450 375 300 225 150 Dollars per Ounce 75 -75 -150 -225 -300 -375 -450 2006 4% 0% -4%

Sources: Diapason, Fed Reserve

-8%

Gold, Comex 12M Actual Change (lhs) Real Interest Rate 12M Actual Change (Inverted, rhs) Real Interest Rate (Inverted, rhs)
2007 2008 2009 2010 2011

8%

Copper Price and Real Interest Rate

Copper Price and Real Interest Rate

7'500 6'000 4'500 3'000
Dollars per Metric Tons

-10%

LME Copper Cash 12M Actual Change (lhs) Real Interest Rate (Inverted, rhs) Real Interest Rate 12M Actual Change (Inverted, rhs)

-8% -6% -4% -2% 0% 2% 4% 6% 8%

1'500 -1'500 -3'000 -4'500 -6'000

Sources: Diapason, Fed Reserve

-7'500 2006 2007 2008 2009 2010 2011 10%

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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 (Winter 2003) Ashwin (blog): Negative Real Interest Rates and the Risk Premium, Macroeconomic Resilience website: http://www.macroresilience.com Gerald Jensen, Jeffrey M. Mercer: Tactical Asset Allocation and Commodity Futures, Northern Illinois University, DeKalb, IL C. Mitchell Conover, Gerald R. Jensen, Robert R. Johnson: Is Now the Time to Add Commodities to Your Portfolio? Journal of Investing (December 2009) Ever B. Vrugt, Rob Bauer, Roderik Molenaar: Dynamic Commodity Timing Strategies (July 2004), ABP Investments Amsterdam, Netherlands Gary Norton, K. Geert Rouwenhorst: Facts And Fantasies about Commodity Futures, NBER and Yale University, February 28, 2005 Jeffrey Frankel: The Effect of Monetary Policy on Real Commodity Prices; Asset Prices and Monetary 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 and Traditional 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, August 10, 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, August 23, 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 requisite knowledge 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 necessary and which they are urged to consult. Diapason Commodities Management S.A. (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 financial products discussed herein, and may at any time make purchases and/or sales as principal or agent. 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 does not 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 with regard thereto or any change in events, conditions or circumstances on which any such statement is based. The information and opinions contained in this document are provided as at the date of the presentation and are subject to change without notice.

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Electronic Communication (E-mail) In the case that this document is sent by E-mail, the E-mail is considered as being confidential and may also be legally privileged. If you are not the addressee you may not copy, forward, disclose or use any part of it. If you have received this message in error, please delete it and all copies from your system and notify the sender immediately by return E-mail. The sender does not accept liability for any errors, omissions, delays in receipt, damage to your system, viruses, interruptions or interferences. Copyright Diapason Commodities Management SA 2011 Any disclosure, copy, reproduction by any means, distribution or other action in reliance on the contents of this document without the prior written consent of Diapason is strictly prohibited and could lead to legal action. Last update on 9 February 2011.

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