Agricultural Commodities – When the Big Elephant Left the Room, By Jim Huang

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US inflation began to pick up in March 2021 and rose rapidly throughout the year. Federal Reserve officials told Americans not to worry. It was due to supply chain issues and comparisons to low baseline numbers in 2020 when economies were shut down.

After CPI rose to 7.0% in December, the Fed voted to keep the Fed Funds rate unchanged at 0-0.25% on January 26th, 2022. Inflation would be “transitory”. Just ignore the big elephant in the room and it would go away. That’s the prevailing thinking at the time.

Then a military conflict took place in the former Soviet bloc. The war shock and ensuing impact from embargo of Russian products pushed the prices of commodities , from gold , nickel, crude oil , natural gas , to winter wheat and many others to record high. On March 16th, the Fed raised rate by 25 basis points with a change of heart. This baby step turned into the most intense battle against inflation with seven consecutive rate hikes.

“Strong Dollar, Weak Commodities” and “High Rate, Low Price” became the dominant theme of the global commodities market. Many commodities gave up early gains and priced at or below prewar levels. US headline inflation rate peaked at 9.1% in June and Core CPI (which excludes food and energy) topped in September. They have come down ever since.

2022 was all about geopolitical crises and central bank actions. Along with investor sentiment, they dominated market trends. Economic fundamentals have been left largely unnoticed.

Outlook for 2023
In the new year, these macro factors would likely stay in the back burners. When the big elephant left the room, fundamentals in each market would once again drive commodities prices. Commodities markets might be less volatile compared to last year.

One notable exception is China. The government ended its strict Zero-Covid policies on December 7th. From January 8th, Chinese tourists would be hitting popular travel destinations around the world, after nearly three-year absence. Normalization of daily life and business activity will not only boost China’s economy, but also lend needed support to the global economy which many believe to be on the verge of a recession.

However, surges in Covid cases raise the risk of new and more deadly virus. By one estimate, up to one billion people are already Covid-positive in China. This is one-eighth of the world population! For a thorough analysis of China’s re-opening and its impact, please check out my previous report, The Rise and Fall of Chinese Yuan.

This concludes a high-level overview before we move to discuss what all these mean for agricultural commodities in 2023.

Fundamental Supply and Demand Built on Higher Baseline
While the big elephant has left, it still casts a shadow in the room. Inflation is sticky. Rate increases have lasting impacts long after the hikes are over.

This is evident in food costs. Inflation pushed the cost of producing, processing, distributing, and selling agricultural products to a high level. November CPI for food items was 10.6%, much higher than the headline CPI of 7.1%. The cost for food at home grew 12% annually, indicating a rapid rise in grocery prices. There are no rate cuts nor deflation in sight. This means that food costs will continue to go up, although at a slower pace.

Wheat , corn , and soybean have different supply and demand fundamentals. But CBOT futures price charts show similar patterns for all three in the past three years. As I pointed out earlier, inflation , geopolitical crisis and Fed rate hikes took turns driving commodities markets across the board. Economic fundamentals got set aside.

Volatility is a friend for options traders. Last June, I introduced a Long Strangle strategy on CBOT Wheat ( ZC ). At the time, wheat price was swung widely by actions in the battlefield. A surprise agreement that allowed Ukrainian grain cargoes to pass the Russia-control Black Sea sent price sharply down, making our put options 400% more valuable.

This year, we will focus on more subtle changes in traditional supply and demand factors, such as planted acreage, weather, yield, and export.

Spread Trade Opportunities
Inflation and rate hikes hit different parts of the agricultural markets differently. For the same commodities , the spread between farm-level price and retail grocery price has become wider due to cost increase.

The commodities used as input in food product and those for output respond to different fundamentals. When inflation and interest rate are moving fast, the traditional price relationship may be temporally dislocated, opening opportunities for spread trades.

Take the example of the Lean Hog market: Last August, USDA Daily Hog and Pork Report showed that benchmark Iowa Carcass Base Price averaged $128/ cwt .

Hog Crush Margin represents production profit by hog farmers. It is defined by the value of lean hog (LH) less the cost of weaned pig ( WP ), corn (C) and soybean meal ( SBM ).

On August 2nd, I presented the trade idea “Short the Hog Margin If You Expect Lower Pork Price”. It’s a profitable trade. On January 6th, USDA benchmark carcass is quoted at $74, a whopping 42% decline in five months.

For this spread trade, I used a Hog Feeding Spread to replicate the economic hog crush margin with CME lean hog (HE), CBOT Corn ( ZC ) and CBOT Soybean Meal (ZM). The size of relevant futures contracts: HE, 40000 lbs .; ZC , 5000 bushels; and ZM, 100 short tons. A typical hog feeding spread is 7:3:1, which may be expressed as:
Hog Feeding Spread = 7 x HE – 3 x ZC – 1 x ZM

As I expect hog margin to shrink, I short the spread: Sell hog, buy corn and meal.

I will continue to monitor the agricultural commodities space in the new year. Whenever spreads or other trade opportunities arise, I will present the new ideas on TradingView.

Happy trading.