Pink Elephants And Collapsing Commodities

Summer days tend to run together, but there’s enough in the way of idiosyncratic news flow to keep things a modicum of interesting this year. That’s due in no small part to an extraordinary macro environment that challenges politicians, policymakers and traders daily.

Recession risk remains top of mind, even as exceptional circumstances raise questions about what counts as a “recession.” The definition is, of course, totally arbitrary, just like almost all concepts that order our lives, so I suppose there’s nothing wrong with redefining the term if common sense dictates.

More important than the application of technical terms tied to arbitrary thresholds and events (“bear market” is another example) is the objective reality that economic momentum is waning, risk assets are impaired, so is consumer sentiment, and it’s all mostly attributable to elevated inflation.

Bill Ackman’s suggestion that market participants focus on nominal growth given the read-through of anomalously high inflation for measures of real activity, likely sounded plausible to many investors, but there’s a sense in which it’s an exercise in question begging. Inflation is the proximate cause for waning growth momentum given the read-through for real wages, margins and thereby consumption and corporate profits. It’s also the catalyst for tighter monetary policy aimed at braking growth via the demand channel.

Ackman, in a series of social media posts, suggested we should look through inflation when assessing the near-term health of the US economy, even as he explained (again) how ruinous inflation can be over the longer-term. That underscores an inherent paradox. Ignoring the elephant in the room won’t help you get perspective. Ackman effectively told half a million social media followers not to think about pink elephants when it comes to near-term recession risk — in a post about pink elephants.

In any event, one question we may need to ask fairly soon is whether markets can price out inflation on their own. If markets say inflation peaked, is that the final word? The simple answer is “clearly not.” Regular people are either paying too much for the goods and services they need or they aren’t. But it’s not that straightforward.

Markets set the price for what people buy after all, and if momentum traders and self-feeding loops conspire to drive crude and other commodities lower, that can impact consumer prices eventually. Sometimes, much-maligned modern market dynamics work out in our favor. The simple figure (below) shows Tuesday’s huge move lower in crude.

“The fall in oil prices started at the US equity market open and coincided with a broad-based decline in other commodities and risky assets,” Goldman’s Damien Courvalin wrote, documenting the factors that contributed to the slide.

“As is repeatedly the case with oil, the move lower was then exacerbated by technical factors and trend-following CTA flows, such as Brent trading through its 100-day moving average, as well as through the strikes of puts with large open interest,” he added, noting that “this selloff occurred amidst seasonally low post-July 4 trading liquidity.”

Courvalin went on to say that in Goldman’s view, there was virtually no fundamental catalyst for Tuesday’s move. While that might be true if by “fundamental” you mean discrete news stories or readily identifiable bearish triggers, pervasive economic gloom and attendant recession hand-wringing are weighing on overall sentiment even if, as Courvalin put it, rising odds of a future recession shouldn’t impact the near-term bullish case for crude as long as the existing oil deficit is unresolved.

But it’s not just crude. Corn and soybeans erased their 2022 gains this week, for example. The Bloomberg Commodity Index is on track for a fourth consecutive weekly decline (figure below).

“Perhaps the best optical capture of the trend reversal from the past year-plus thematic zeitgeist, as the market moves from ‘Inflation Overshoot’ and ‘Rates Re-Pricing’ to ‘Recession / Contraction’ is the absolute destruction of everybody’s favorite inflation long,” Nomura’s Charlie McElligott said, referencing raw materials.

Recall that Nomura’s CTA Trend model showed net (long) exposure in commodities dropped from from 99%ile In February and March to just 35%ile in recent weeks.

Bloomberg’s spot index is teetering on the brink of a bear market (figure below).

“Commodities’ fall from grace has been swift and brutal,” Bloomberg’s Jake Lloyd-Smith wrote Wednesday, from Singapore. “The selloff has been driven by concerns a nasty, demand-shredding recession lies just around the corner, as well as the dollar’s heady ascent.”

The across-the-board nature of the selloff is notable. It’s “punishing raw materials that can boast positive underlying fundamentals” Lloyd-Smith added.

“Most bank-integrated oil teams are still hollering ‘not all commodities are created equal!’ and are sticking to bullish price forecasts,” SPI Asset Management’s Stephen Innes said Wednesday. “For now, the pass-through into a rally in global fixed income is straightforward, driven by lower forward inflation expectations and a lower trajectory for CPI inflation priced by swaps.”

That’s important. The Fed watches the bond market and, in many cases, takes its cues from rates, which in turn trade on policy expectations.

All of this may prove ephemeral. There are good arguments to be made that a wage-price spiral is already embedded across developed economies, and the fundamental case for commodities is strong. The odds of inflation receding rapidly in the near-term are still remote.

Nevertheless, it does feel like inflation expressions — from breakevens to commodities — are one major lockdown in China away from wholesale capitulation. That’d have knock-on effects for Fed pricing and could prompt traders to get even more aggressive when it comes to fading Jerome Powell’s pretensions to a terminal rate near 4%.