January 19 - Price is a function of supply and demand, but as modified by the flow of money. Managed money controlled by algorithms make up a large portion of today's commodity markets, from crude oil to live cattle. Some of that managed money is there because it sees an opportunity to make money being either long or short a commodity, or the commodity sector at large. Some of that money is present simply because it balances out overall portfolio objectives, while there are other motivations as well. The algorithm computers simply speed up the implementation of the fund objectives, often to a fraction of a second. Supply and demand remain vital components of determining a fair value for a particular commodity, but the market's perception of the overall economy shapes its objectives for involvement in the sector, and that also influences how the market manages supply and demand.
A simple regression study utilizes historical price versus stocks relationships to determine a fair value for a commodity. But my study of marketing year average cash prices for corn and soybeans found that average cash prices frequently came in well above, or well below the projected levels determined by those historical relationships. The primary factor that seemed to determine whether a particular year would end up with a higher or lower price than projected by the price regression study was the market's perception of whether we were in an inflationary period or a deflationary period. In other words, the market tended to manage the same supply and demand fundamentals at different price levels, all the way to the farm gate, depending on whether fund managers felt that we were moving into an inflationary period, or if we were moving into a potential recession and/or deflationary period.
The five-Year Breakeven Inflation Rate reflects the market's perception of whether the average inflation rate will be rising in the years ahead or whether it will be in decline. The below graphic shows rising inflation expectations coming out of the pandemic in 2020, but declining expectations as the Fed began to ramp up interest rates in 2022. History shows that the value of a broad basket of commodities - our StoneX Commodity Tracker in this case - rises and falls with these expectations, with a 10-year correlation of a strong 0.87. Fund managers tend to build long positions of ownership to protect their portfolios in times of inflationary expectations, while shorting the commodities in times of expected declining inflation, which has been the case since roughly June 2022. Those inflation expectations are leveling off currently, with some talk that they may rebound later in 2024. The funds hold large short positions in most commodities today, so would that mean a reversal? That's a question likely to be answered in the second or third quarter of this year.
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