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:

Lumber Futures Curves, yesterday (orange), 6 months ago (green), 1 year ago (blue)

(Click on image to enlarge)

Source: Bloomberg

We can see that even though futures markets are indicating lower prices in the future than they are at present, those future prices are well above those that we saw last year. If lumber was the only component in an inflation index, we could say that markets are implying that while the current spike in prices is indeed shocking, it is transitory and likely to improve. On a month-over-month basis, we would expect to see lumber inflation fall. But year-over-year, we are still expecting a big increase. Much of this depends upon timing and perspective.

Bear in mind, of course, that inflationary measures take much more into account than a single commodity or even a basket of tradeable commodities. Other goods and services play a huge role, and they are much harder to anticipate, certainly for a non-economist like me. That said, labor is a key component of inflationary measures. We are likely to get a clearer view of labor cost pressures when the monthly labor report is released tomorrow morning. The current consensus is for an increase of about 1 million non-farm payrolls and no monthly increase in hourly wages. That would be catnip for a Fed that is determined to keep monetary stimulus in place until or unless they see full employment and inflation of 2%. A significant deviation in either of those statistics (or the others that will be reported) could surprise investors and change the tone of the inflationary debate. Stay tuned.

[1]  I did something similar in real life yesterday. I’m on the board of a local non-profit, and they asked me for guidance in budgeting heating oil costs for the next year. I looked at the HO futures, came up with an average of futures prices for the relevant period, then added the customary premium that our vendor charges above the prevailing spot price.