Commodity Inflation Risk: Explaining Commodity Returns and Predicting Equity Premium

We propose a novel measure of the commodity inflation risk premium (cIRP) based on a term structure model of commodity futures. The forward-looking cIRP measures of all commodities yield a new characteristic explaining the cross-section of commodity returns well, generating the highest Sharpe ratio among all existing characteristics. Furthermore, the aggregated cIRP measure significantly predicts the stock market even after controlling for major economic predictors, including the traditional inflation level. Our results show that commodity inflation risk plays an important role in commodity pricing, revealing a strong link between commodity markets and equities. Separately, the commodity futures term structure literature has long employed multi-factor models (e.g., Gibson and Schwartz, 1990; Casassus and Collin-Dufresne, 2005; Chiang, Hughen, and Sagi, 2015) to extract short- and long-term economic information. Our study joins this literature and translates raw futures price dynamics into interpretable measures, thus bridging the gap between equity and commodity market behavior.