Commodity Market Interest and Asset Return Predictability ∗

We establish several new findings on the relation between open interest in commodity markets and asset returns. High commodity market activity, as measured by high open-interest growth, predicts high commodity returns and low bond returns. Openinterest growth is a more powerful and robust predictor of commodity returns than other known predictors such as the short rate, the yield spread, the basis, and hedging pressure. Although positively correlated with commodity returns, open-interest growth contains information for future asset returns beyond contemporaneous commodity prices. Open-interest growth also predicts changes in inflation and inflation expectations. These findings suggest that open-interest growth contains information about future inflation that gets priced into commodity and bond markets with delay. Our findings are consistent with recent theories of gradual information diffusion and have implications for macroeconomic forecasting models. ∗This paper subsumes our earlier work titled “Digging into Commodities”. For comments and discussions, we thank Erkko Etula, Hong Liu, David Robinson, Nikolai Roussanov, Allan Timmermann, and seminar participants at Boston College, Centre de Recherche en Economie et Statistique, Dartmouth College, Federal Reserve Bank of Chicago, Fordham University, Imperial College London, Ohio State University, PanAgora Asset Management, Stockholm School of Economics, University of California San Diego, University of Minnesota, University of Pennsylvania, University of Southern California, University of Texas at Austin, Washington University in St. Louis, the 2008 Economic Research Initiatives at Duke Conference on Identification Issues in Economics, and the 2010 Annual Meeting of the American Finance Association. We thank Jennifer Kwok, Hui Fang, Yupeng Liu, James Luo, Thien Nguyen, and Elizabeth So for research assistance. Hong acknowledges a grant from the National Science Foundation. Yogo acknowledges a grant from the Rodney L. White Center for Financial Research at the University of Pennsylvania. †Princeton University and NBER (e-mail: [email protected]) ‡University of Pennsylvania and NBER (e-mail: [email protected])