This is the 2nd installment of “The Great Wall Street Repricing” series.
The price of a commodity is determined by the interaction between the demand and supply of its market. This year, such interaction acts like a Tug of War. On the one hand, tight supply pushes commodity price upward; on the other hand, weak demand pulls the price back down. Commodity prices swing wildly as each side battles for supremacy.
News that signals supply disruption sends prices flying. It could be geopolitical tension, bad weather, restrictive government policy, or an oil tanker stuck in the Suez Canal. Meanwhile, high , weak housing market, disappointing retail sales, and Fed rate hikes all raise worry of a global recession and the consequential demand reduction.
Not all are created equal. I have made some interesting observation: primarily used as a production input hold up much better than those being consumed by end users. To prove my point, let’s review the price data at market close on September 2nd.
In the energy market:
• WTI crude oil ( NYMEX:CL1! ) is settled at $86.4 per barrel, down 11.9% month-to-date ( MTD )
• RBOB gasoline ( NYMEX:RB1! ) closes at $2.38 a gallon, down 23.3% MTD
• Oil Supply: There is no elasticity. Crude oil production capacity is capped in any given year
• Demand elasticity: Consumers could adjust their driving habit in response to
American Automobile Association ( AAA ) reports today that national average retail price of regular gasoline is $3.809, down 9.1% MTD , but diesel, at $5.067 a gallon, is down less than 4% MTD . Why? Diesel is mainly used for highway transportation of goods by trucks. Delivery routine has less flexibility to change comparing to consumer driving behavior.
In the food market:
• Corn ( CBOT:ZC1! ), a main ingredient in livestock and poultry feed, closed at $6.58 per bushel, up 6.7% MTD
• Lean hog ( CME:HE1! ) is settled at $0.919 per pound, down 3.7% MTD
• Corn price is vert sensitive to supply factors such as plant acreage, weather, and yield
• Hog price is more correlated to demand factors, including export of US pork, and consumer changes of dietary habit
• Pork has substitutes. When it gets expensive, consumers could switch to cheaper meat. People in poorer countries could simply reduce meat consumption
On August 2nd, I expressed my view in a trade idea titled “Short the Hog Margin if You Expect Lower Pork Price” https://www.tradingview.com/chart/HE1!/8CNdWDNR-Short-the-Hog-Margin-If-You-Expect-Lower-Pork-Price/
In the metals market:
• High Grade Copper ( COMEX:HG1! ) closed at $3.408 per pound, down 4.2% MTD
• Silver ( COMEX:SI1! ) is settled at $17.655 per troy ounce, down 12.6% MTD
• Both copper and silver are industrial materials. They declined in response to economic slowdown, but there is a significant difference
• About 50% of silver supply is used in industrial applications, with the other 50% being used as a previous metal or for daily use
• Consumers will buy less silver jewelry in tough times. This explains why silver declined three times as much as copper .
In the credit market:
• 2-Year Treasury yield ( CBOT_MINI:2YY1! ) closed at 3.514%, up from 2.950% last month
• 10-Year Treasury yield ( CBOT_MINI:10Y1! ) settled at 3.272%, up from 2.727% last month
• Both went up in response to Fed’s rate hikes, but there is a difference
• 2-Year Note has a direct relationship with Fed Funds rate. It reflects the cost of money (rate hike) and the supply of money (quantitative tightening)
• The yield of 10-Year Note also reflects money demand in addition to money supply
• In an economic downturn, businesses and consumers will reduce borrowings. The spread between deposit interest and lending rate will be tightened
• This makes sense – with lower loan , banks are willing to make less
What about High Interest Rate and High Inflation
In the first installment, we discussed the impact of high rate and high from the perspective of discounted cash flow valuation model.
• High interest rate increases the discount factor, the denominator of the equation
• High increases production cost and reduces sales, which results in smaller free cash flow, the numerator of the same equation
• The combined effect is a lower stock valuation
means higher price. It is generally good for those primarily used as production input, such as natural resources. Energy producers, metal dealers and mining companies have all made record profit this year. However, if persistent eventually leads to a recession, commodity price would fall due to lower demand.
It’s an entirely different story for companies producing bulk consumer products. As we discussed earlier, hog farmers get squeezed by higher feed cost and lower meat price. Jewelers would find customer traffic significantly reduced due to higher prices of gold and silver jewelry.
The impact of higher interest rates is more uniform for most . It increases the borrowing costs on anyone engaged in producing, processing, transporting, and using the . Higher cost results in lower usage, which would depress commodity price.
In addition, a strong dollar raises the price for overseas consumers when they pay with a weaker foreign currency.
I think we have covered a lot today. Let’s take some time to digest and identify market opportunities with these observations.
Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. TradingView users already have access to delayed data. A Pro user could upgrade to real-time market data for only $4 a month, a huge discount at the time of high .
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.