Why All Investors Should be Watching Commodity Prices

As investors wake up to yet another scare about potential problems with banks, this time in Europe, we could all do with some good news. The problems in banking suggest some unintended negative consequences of rate hikes, but if we look beyond that, to the root causes of the inflation that necessitated the hikes in the first place, there is some good news, or at least some hope, to be found.

Yes, the market is coming to terms with the fact that higher rates mean lower bond prices which, in turn, means more expenditure by banks to maintain their required capital ratios. Yes, “emergency” borrowing by banks in the U.S. has spiked, and yes, the Fed and other central banks around the world are refusing to let the present reality intrude on their plans and are still raising interest rates, but does that mean that we are hurtling towards disaster?

Not necessarily. There is a way out of here. If inflation reduces significantly over the next few months and central banks react to that by halting and in some cases even reversing rate hikes, then a “soft landing” is a real possibility. So, what are the chances of that happening?

To answer that question, you first have to identify why inflation is so high. There are basically two types of inflation, one that is caused by an increase in demand, not matched by increased supply, that creates scarcity and pulls prices higher. The other is the result of an increase in raw material costs due to scarcity there that pulls prices higher. This particular bout of inflation we're going through seems to be a bit of both.

A decade or so of essentially free money created higher demand, but supply failed to keep up, as evidenced by a massive spike in commodity prices.

The five-year chart for the Invesco DB Commodity Index ETF (DBC) shows the extent of that spike. The inevitable drop during the throes of the pandemic had been recovered by early 2021, but commodity prices continued to increase well beyond that. That is a clear visual depiction of inflation, but the chart also suggests that commodity prices peaked in June of last year, and are now trending downwards.

Not only that, but when you look at individual commodities within the category, there is even more reason for optimism. The index tracks an average of all commodities, but not all of them influence prices in the economy. Gold, for example, has little to no impact as it is not really used for anything, and that has risen by more than 20% over the last five months, while the major commodities with a practical use, things like oil, natural gas, and lumber have fallen quite sharply and are basically back to pre-covid levels.

There are two ways to look at that, one negative and one positive.

The negative is that commodity prices are often leading indicators for the economy. If demand for raw materials is falling, then it suggests an economic contraction that is yet to show in the data. On the positive side, though, if higher input costs were a root cause of inflation, then a dramatic pull back in commodities is a good thing.

This is actually a case of something that people often struggle to understand -- two things can be true at the same time. Lumber’s big fall, for example, is probably at least in part attributable to the fact that higher interest rates will slow the housing market, while oil prices are dropping in expectation of slower growth. However, that is what is supposed to happen. It is how markets work, and why many economic problems are essentially self-solving. Those lower prices may be the result of pessimism, but they will slow inflation.

What is important, though, is where those prices go from here. If both oil and lumber continue their slides and drop back significantly below their pre-Covid levels, then the “trouble ahead” message becomes louder and clearer, whereas if they stabilize at around their current levels, it is more about the markets doing their thing, and a soft landing will look the most likely outcome later this year.

Many traders and investors pay little attention to commodities. They often don’t trade them directly, so they essentially ignore them when they are not in the headlines. Now is not the time to do that. We are precariously poised between two possible outcomes, a full-on recession and a more orderly slowdown followed by a strong recovery. Commodity prices will give us the best available indication of which way the chips will fall, and what we will see over the next year or so. We should, therefore, all be paying attention.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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