Financialization and Commodity Market Serial Dependence

Recent financialization in the commodity market makes it easier for institutional investors to trade a portfolio of commodities via various commodity index products. Using news-based sentiment measures, we find that such trading can propagate non-fundamental shocks from some commodities to others in the same index, giving rise to price overshoots and subsequent reversals, or “excessive co-movement” at daily frequency. Excessive co-comovement results in negative daily commodity return autocorrelations even at the index level (but not for nonindexed commodities) and such autocorrelations move with our commodity index exposure measures. Taking advantage of the fact that index weights of the same commodity can vary across different indices in a relatively ad-hoc and pre-determined fashion, we provide causal evidence that index trading drives excessive co-movement. Finally, we confirm that our results are not driven by the large commodity boom-and-bust during the recent financial crisis.