Perspective: Morning Commentary for December 28

By: Arlan Suderman, Chief Commodities Economist

Wed, 28 Dec 2022, 14:46

Perspective: Morning Commentary

Arlan Suderman

Chief Commodities Economist

December 28 – Cautious optimism provided modest support for stock futures overnight, with traders focused on expectations that China’s economy will reopen sooner rather than later as Covid rapidly spreads through the country. The VIX continues to consolidate near 21 this morning, while the dollar index trades near 104.0. Yields on 10-year Treasuries are trading near 3.83%, while yields on 2-year Treasuries are trading near 4.34%. Crude oil prices are mixed with a weaker bias this morning, while the grain and oilseed markets are mixed to firmer.

Wall Street’s obsession with the inverted yield curve continues. Traders see the inversion not as a cause of a recession, but as a predictor of a recession. In reality, it is typically a reflection of their expectations being self-fulfilled. But I would argue that something else is at work here as well. I would argue that the inversion is a better indicator of trader expectations of what the Federal Reserve is going to do. Short-term Treasury yields reflect what the Fed is currently doing – raising interest rates at a fairly fast pace. Longer-term Treasury yields reflect what traders expect the Fed to do down the road – cut interest rates. The Fed continues to argue that it plans on taking interest rates higher and for longer than anticipated by the market, essentially raising expectations at each meeting. However, the market continues to believe that the Fed will not have the stomach to do so when the economy starts to experience more significant pain. The Fed says that pain is necessary to tame wage inflation, which is a core part of overall inflation, but again, the market doesn’t think that the Fed has the stomach to do so. That’s why Fed fund futures trading shows peak interest rates at just over 4.75%, with rates starting to decline by the end of the year. Why then should they push yields on 10-year Treasuries higher when traders expect rates to start falling within the next 12 months? That’s a big reason why we’ve seen such a large yield inversion. However, that inversion has narrowed by roughly 30 basis points over the past two weeks, with yields on the 10-year rallying while yields on the 2-year only firm slightly, suggesting that the market is starting to recognize that the Fed may actually do what it says, which is take rates higher for longer than previously believed.

Hospitals are said to be at capacity and beyond in major cities of China, with nearly all of the patients battling Covid. We continue to hear reports of morgues overwhelmed due to the outbreak, while official death tolls remain quite low. Half or more of China’s urban population has likely been exposed to Covid already, although the more significant questions continue to revolve around the 500 million rural and mostly elderly residents, where Covid is just beginning to move through the population. There is not question that the current outbreak is making life difficult for Chinese citizens, with a significant impact on the nation’s economy. However, Wall Street continues to be focused on the behavior of citizens who have recovered from Covid, who appear eager to quickly experience their new-found freedoms in the Chinese economy. Lines are forming again at restaurants and subway stations as people seek to return to “normal” life again. Covid restrictions have been removed, allowing people to travel within the country, but also to travel outside of China and to easily return. Internet searches for international travel are surging, although it will take time for the airlines to re-establish travel routes and connections. Nonetheless, we continue to see evidence that China’s economy will be able to see a vibrant rebound relatively early in 2023. That is not only good for the Chinese economy, but it’s also good for the global economy as it increases demand for commodities, as well as other goods and services. The biggest question remains though, how deep will be the hole that China’s economy will recovering from? That question can’t be answered just yet.

Grain and oilseed trading continues under thin holiday conditions, which will be the case through the remainder of the week. The grain and oilseed sector has largely seen a positive bias in recent days amid some talk of fund money coming back to the overall commodity sector as China prepares to rebound from its Covid shutdowns. It’s premature to say that this is a macro-market development that will fuel a renewed surge in commodity prices in 2023. Wall Street continues to largely be focused on recession risks, which are considered negative for commodity demand. China’s ability to come out of its three-year lockdown will be key to shaping Wall Street’s view of the commodity sector in the weeks and months ahead. Fundamentally, very little has changed over the past month, but fund managers tend to look at the same fundamentals differently, depending on their view of the macro-economic picture. I’ve been saying for the past four to six months that I believe we could see considerable volatility in the commodity sector in 2023, but that’s going to largely hinge on the above China factors, as well as what happens in the Ukraine war to impact crude oil and natural gas supplies in the months ahead.

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