Indexing Bond And Commodity Markets In The World Of The Upside Down

In the 80s nostalgia Netflix hit series “Stranger Things,” the town of Hawkins is haunted by an alternate world beneath. The protagonists battle monsters in what they call the upside down. For the first few seasons, the upside down wreaks havoc on just a few residents of Hawkins. By the last season, no one is safe from the destruction, despite all the local and federal support to stop it. A similar theme is developing in bond and commodity markets. We are seeing “upside down” or inverted yield curves and commodity markets in backwardation, or prices higher today than they will be in the future. Like the Netflix series, this has started by only affecting certain fixed income and commodity traders, leaving the broader economy out of recession for now (more on that later). As in the show, it takes a tremendous amount of government intervention (which can be partly blamed in both the show and reality) to cull the beast and bring back stability. In this blog post, we will examine various markets that are upside down, or inverted. Starting with the yield curve, we then highlight some lesser-known financial markets that are also in the upside down.

The inverted yield curve has widely been pronounced as a terrific measure of recessions. We are now in the deepest inversion in over 40 years, and the Fed continues to deliberate on the number of rate increases, not cuts, to bring the shape back to normal. On average, the U.S. economy dips into recession 11 months after the three-month yield eclipses the 10-year yield. For those counting at home, the current inversion began in August 2022, or eight months ago.

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Another more morbid measure that’s currently inverted is the market for U.S. Credit Default Swaps (CDS). These are contracts that pay out in the event of a U.S. government default. As unlikely as that may seem, the cost to protect against such a calamitous event has risen significantly. One-year U.S. CDS protection now costs 88 bp. Concerns about U.S. solvency are not as well bid further out the curve. From the inverted shape of that market, it would imply concern about a government shutdown and failure to pay treasury debt in the short term.

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A third inverted market is select commodity futures, many of which have been inverted since 2020. Currently, 74% of the index weight of S&P GSCI components are trading at higher prices for one-month delivery than one year.Brent Crude and West Texas Intermediate one-month futures are about USD 4 higher than the 12-month futures price, while unleaded gas is 28 cents cheaper for one year out than one month (see Exhibit 3). Energy isn’t the only market that exhibits backwardation (lower prices in the future). Corn, soybeans, sugar, and Kansas wheat are all showing the same phenomena.

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What can market participants make of all these negative signs? All tend to point to short-term dislocation and long-term normalization, as the front end of each curve exhibits the greatest deviation from past measures. Futures prices for interest rates and commodities markets are indicating lower rates in the future than what the spot market trades at now. This could indicate one of two things: expectations of current supply and demand constraints will be alleviated in the future, or a significant decline in risk assets resulting from economic slowdown. The Fed’s efforts to curb inflation and create price stability in the short term has resulted in many market inversions. This has led to short-term yields exceeding 5% for one-year debt.Monitoring longer-term interest rates and commodities prices helps measure how effective that goal is and if it’s hurting the broader economy. For now, it’s enough to keep the upside down under wraps to the broader economy. How many seasons this series will go on before recession remains to be seen.

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