More About Backwardation And Transitory Inflation

Yesterday’s piece addressed the concepts of contango and backwardation in futures markets. We asserted that backwardation in many of the hottest commodity futures can be used by the Federal Reserve to rationalize their viewpoint that inflation is transitory. Today I’d like to continue looking into commodity futures and the inflation messages that they may be sending.

I came across the following chart on Bloomberg yesterday:

The primary message of the chart is quite clear. Commodities markets are seeing the highest rate of backwardation that they have experienced in more than 14 years. That certainly sounds ominous, and at one level it is indeed the case. Remember how we defined backwardation yesterday:

“It implies an abnormal state, and a commodity that is experiencing shortages tends to be in backwardation. If demand outstrips supply in the short term but is expected to normalize at some point in the ensuing months, we tend to see a curve in backwardation.”

It should come as no surprise to market participants who have been closely following financial news that there are shortages in a wide range of intermediate and consumer goods. Semiconductors have gotten much of the publicity, but they are not exchange-traded commodities. Lumber and copper are indeed exchange-traded, and the former is in steep backwardation. So are foodstuffs like soybeans, corn, and wheat. Oil is also in backwardation, but that is not an unusual state of affairs (it is quite expensive to store oil). 

If I were at the Fed, trying to anticipate inflation, I would certainly look to futures markets for guidance [1]. The futures markets are telling me that while we are clearly experiencing imbalances in supply and demand across a wide range of commodities, the lower prices for outer month futures in commodities that are experiencing backwardation can imply that the imbalance is likely to be resolved somewhat.

As we noted yesterday, however, there are flaws in this approach. Many of the markets that are in backwardation are still implying much higher prices for the coming year than we experienced over the prior year. That, dear readers, is pretty much the very definition of inflation. Let’s revisit a chart that we used yesterday:

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