Commodity analysts spend a lot of time poring over and discussing fundamental drivers of market shifts, but external factors, like macroeconomic shifts, can magnify or dampen the influence of core supply and demand fundamentals on commodity prices.
U.S. and global economic dynamics have been the subject of much discussion, with many questions still unanswered. Is China’s growth slowing? Are eurozone economies poised for a downturn? Has the U.S. stock market risen too fast, too soon, and is it due for a major downward retracement? Can U.S. quarterly GDP growth consistently stay above 3 percent?
We may not have solid answers yet, but one recent market development, yield curve inversion, is getting plenty of attention from market watchers who know their market history. If equity, bond, and commodity traders are paying attention, you may do well to follow suit.
What is yield curve inversion?
In bond markets, a yield curve inversion describes a period when shorter-term bonds see higher yields than those on longer-term bonds. Currently, the yield (the return bond investors realize) on the ten-year bond is lower than for a three-year bond. Basic economic theory posits that the longer-term bonds should command a higher interest rate, partly due to higher inflation and interest rate risks, so it is notable when the reverse of this is seen in the market.
All sorts of investors take note of yield curve inversions because this market aberration has historically signaled the advent of a recessionary period. Yes, past performance doesn’t necessarily determine future market behavior, but this market anomaly preceded recessions in 1978, 1989, 1998, and 2006.
What’s the significance for commodity prices?
As a rule of thumb, recessions are followed by commodity market price spikes—irrespective of the underlying commodities’ fundamentals. Speculators may seek the safety of commodity markets during economic downturns: though tough financial times may cause consumers to hold off on new iPhones and cars, they will still purchase basic or necessity goods like food and energy, at least in theory.
The most recent example of this was seen in 2007 and 2008. Bond yield inversion seen in 2006 was followed by a strong but temporary rally in the stock market. But by late 2006, speculative money began flowing into commodities markets, driving them higher. For example, between September 2006 and their peak in May 2008, soybean futures jumped 213 percent. Corn futures values jumped 237 percent. After troughing in January 2007, crude oil futures rose 187 percent before peaking near $145 per barrel.
This is not to say that such price jumps are necessarily forthcoming. The 2008 recession was exceptional, one of the worst economic downturns in modern history, and we are hardly suggesting that its widespread effects will be duplicated fully in a more typical recessionary scenario.
The lesson is that both economic patterns and speculative behavior may merit close attention in months ahead. Many markets show net-short positions (corn, soybeans, soybean oil, cocoa, etc.) at this time, and this may be at least partly behind recent price weakness for these commodities.
In an environment of fundamental bearishness, it’s always wise to consider what-if scenarios that may shake up markets—even less typical ones like this yield inversion.