29 November 2018
Following several decades of neglect, ECB Chairman Mario Draghi is reintroducing commodities curves to central bank inflation forecasts. This is a welcome development, according to GAM Investments’ Joachim Corbach and Christian Gerlach, but some fine tuning appears to be required.
Commodities exposure has traditionally proved a valuable hedge against inflation in a portfolio context, since rising commodities prices directly feed into headline inflation. If we venture back to Paul Volcker’s time as Federal Reserve chairman, he incorporated the information gleaned from commodities curves in making inflation forecasts… and rightly so, in our view. In the late 1970s inflation had reached post-war peaks, largely driven by a huge spike in oil prices. However, in the 1980s central bank policy took a dramatic shift from responding to inflation to attempting to circumvent its influence through pre-emptive rate hikes, which acted to kill inflation. This saw the analysis of commodities curves fall out of favour among central bankers. The period that followed will go down in history as the so-called ‘great moderation’ where interest rates progressively moved into a narrower range as inflation became constrained.
Nevertheless, many academics have subsequently argued that the influx of cheap imported goods was more of a factor in constraining inflation than successful monetary policy. If this is indeed the case, it seems appropriate that central bankers should reconsider commodities curves as a primary input to inflation forecasts. In this respect, Mario Draghi is leading the way but, as yet, he does not appear to have come to grips with one of the least understood dynamics that can confound investors.
One curve, two forms
Commodities curves take two particular forms.
‘Backwardation’ is technically where the spot price is higher than the future price, but to simplify further, effectively represents a scenario where there is more demand than supply, leading to higher prices. Conversely, ‘contango’ exists when surplus outweighs demand and therefore leads to falling prices. The sole function of the commodities futures curve is to match demand and supply in the spot market. A curve in backwardation, for example, pushes the supply from the future to the present, and at the same time postpones demand. This is how the situation of demand outstripping supply gets mitigated. There is no expectation attached to it; it purely highlights an arbitrage situation.
We acknowledge these terms can be confusing and upon reviewing notes from recent ECB meetings, it would appear that even Mario Draghi has misinterpreted the information from commodities curves. He seems to infer that contango – a state that we witnessed for an extended period as the oil price slumped – was consistent with rising inflation expectations, and vice versa. In many ways, this confusion is understandable for a central bank chairman. Mr Draghi is in his comfort zone when considering the bond yield curve.
The yield curve consists of multiple bonds and serves to block these together across the spectrum of maturities and consequently derive expectations about the future, whereas we have already shown that the commodities curve bears no relation to future price expectation.
Therefore nub of any misunderstanding over the interpretation of commodities curves, in our view, seems to relate to a lack of familiarity with the terminology surrounding commodities in contrast with the high usage of language use to describe bonds. To us, the terms ‘backwardation’ and ‘inversion’ instinctively sound like two different ways of explaining the same thing, when, in fact, they are complete opposites.
In summary, we believe central bankers can glean a lot of information from commodities and yield curves but the interpretation is a lot tougher than it may first appear. The shape of the commodity curve provides a potential signal of unexpected inflationary or deflationary pressures, which is important to consider in policy models. In our view, the yield curve is an absolute indicator of expected inflation / deflation, so using the two together makes a lot of sense. However, it is really important to marry the appropriate curves. Commodities prices in contango and an inverted yield curve collectively portend deflation and vice versa.
Finally, as commodities investors it would be remiss of us not to point out that bond yield curves are currently more or less flat, while commodities curves are not providing clear signals as to whether we can expect inflationary or deflationary pressure. But even in this situation, we believe it is potentially a good time to be considering the addition of commodities exposure to a diversified investment portfolio, both in absolute terms and as an inflationary hedge.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of future performance and current or future trends.