Month End Summary of Commodity Futures and Options

Oh the collective pearl clutching displayed among the investing class! Peter Lynch is reputed to have said (paraphrasing), “Markets sometimes go down 20%, if you can’t stomach that, stay in CDs and savings accounts.” The logic in this statement is irrefutable, yet all we hear from clients is, “I am too busy to talk about risk, the markets are moving”. Like a flood or a house fire, you should worry about the risk before the bad outcome occurs. A market maker, broker or commodity merchant has no choice but to monitor and hang on every tick, that is an artifact of their business. If you are an investor, asset owner or even a fund, your time horizon should treat these events as blips-potential buying opportunities or just a tantrum that should be ignored. Not one bit of the tariff tit for tat was unforeseeable. Robert Haugen wrote extensively about avoiding volatility. Nothing realizes volatility like selling into a panic.

This tantrum is a great example of Robert Haugen’s insight. The Nasdaq futures have fully retraced their move. The other equity indexes are well off lows. Things are so bad in the modern world that even our “crashes” don’t last. More importantly, if you went with the passion and sold with the crowd, you are eating crow. You bought your broker his next yacht.

The risks haven’t changed. Mr Trump’s initiatives at the 100 day mark are not exactly resounding successes. The sanctions game is not resolving itself in the 1-2-3 format that people expected. Yes, the administration is claiming discussions, but the ports at Long Beach and elsewhere are emptying out. It is an economic fact that smaller economies accrue more gains from trade than the larger country. Extracting some of this surplus from the rest of the world might be a laudable goal (from the view of US residents), but one might perceive pushback from the rest of the world. Moreover, it isn’t clear how one would extract that surplus. If the dollar strengthens, then US exports become more expensive and the economy becomes more import oriented, albeit at better terms of trade. Conversely, cheapening the dollar has the opposite effect. Whose surplus is more sacred? The producers in the economy or the consumers? We can sympathize with Mr Trump’s conundrum, the US is paying for baubles with IOUs or other assets. Clearly, this ends at some point. The IOUs will trade for lower and lower prices and the attractive assets the US can offer foreigners will eventually run out. The current administration is now seeing that, while, the country and economy will equilibrate (through lower standards of living), the ability to act as an empire is greatly hemmed in. Without robust domestic manufacturing, sustaining a Russo-Ukrainian type war (and the associated attrition) is impossible. We predict that even if Mr. Trump is voted out (or impeached out), the generally aggressive tone will not fade. The DC Powers That Be are busying themselves with putting Humpty-Dumpty back together again! We are sure that this will go swimmingly.

The trade battle between China and the US is a lot like watching two aging heavyweight boxers in the late rounds. Both sides have shaky legs and will start to clench and hug, all the while looking to land the mighty haymaker. A full reduction in trade with China will act to increase the cost of living in the US. Not even the most ardent Trump supporters expect sweat shops to start employing Americans domestically. Trade, like water, finds a way to flow, however, it will take time to set up transshipment via third countries. These will all add drags to the supply chain, undoing the gains from globalization. The Chinese are also facing all sorts of overhangs. They’ve spent most of the 2000s building an export engine. It scours the Earth for materials and then ships the finished products to the US (and Europe). How long can it tolerate no trade? How much finished goods can be shunted to Europe, South America or Africa? The US will suffer higher prices on Amazon or at Walmart. The unemployment may be outsourced to China. We think that the churn from the sanctions tit-for-tat will be an overhang for the foreseeable future, only time will tell which boxer will drop first.

Another of the administration’s initiatives is stopping the war in the Ukraine. We have been skeptical of the President’s bombastic statements about ending the war quickly. While the Russians will pay lip service to all initiatives coming from the new administration, they are not the naive rubes of the 2000s. They see an existential threat coming from the West. They are winning. They are in the process of denuding the West of weapons stores and the Ukraine of manpower. Why would they want a hasty conclusion to something which is making their position better and better? Sergei Lavrov, the Russian Foreign Minister, is quoted as expressing worry that a removal of American sanctions could cause a flood of cheap goods into the Russian market, displacing local producers. This is a far cry from them quaking at the prospect of secondary or tertiary sanctions. The US vacillates from threats to walk out of the Ukrainian conflict to threatening further sanctions on oil and other Russian exports. The US could potentially send energy prices up or down via sanctions-especially if they crack down on Indian, Chinese and European purchasers of Russian hydrocarbons. Even if the US extricates itself from its Ukrainian involvement, the Europeans seem to be digging in. We expect the situation to continue. The conflict will be resolved by military means, and that will put a lot of pressure on the toothless Europeans.

The Middle East is also roiled by conflict. It is encouraging that the current administration seems to be negotiating with Iran, even as it bombs or drones the Houthis. The uncertainty here is very high. The Arab world seems to want no part in a war, against its Persian neighbor. There is, however, a large bipartisan US desire for war with Iran. A break through that forestalls an American attack on Iran probably puts downward pressure on oil. A war, on the other hand, gooses prices. We would be remiss in not speaking about the Indopakistani tensions that could erupt into conflict at any moment. If the conflict stays non-nuclear, then it should have minimal economic effects on oil or other commodities.

Looking back at the dynamics in the options market, we see typical behavior. The rally wipes out implied vol as the rolling (statistical) volatility continues to be elevated.

An interesting thing that pops out in this period is how prices and volatility are much more correlated during this stress period.

The correlations between vols and futures increase dramatically and across all sorts of assets. Most people assume that the stiffening correlations concern only the futures, but the correlations increase increase between vols as well.

We now proceed to our dive into the different market segments and our observations.

The cryptos are bifurcated. Bitcoin ended up on the month, but Ethereum came off aggressively. Vol was offered in Bitcoin and slightly higher in ETH. The price increase in BTC is consistent with some flight to 'quality'. The conventional currencies all rallied against the USD. Vol in all currency pairs was strongly bid. If there is a direct slave to the tariff drama, it would be FX. The tariff issue resolution affects terms of trade and sovereign risk.

The current scuttlebutt is that there are 4 cuts of 1/4 point expected in the discount rate. The short end of the curve rallied in the face of these expectations. We repeat that the last rate cut resulted in higher nominal rates. We see the Ultrabond and 30 Year contract falling. We don't see how a rate cut mitigates the pure supply side shock of the tariffs and their disruptions. The chattering classes know only one tool-rate cuts. All prescriptions then involve varying degrees of rate cuts. A lot of peoples' understanding of interest rate policy is very mechanical, rates down imply greater economic activity. The incredibly low rate regime that people have grown accustomed to (2000 to 2023 or so) also coincides with lots of gains from trade. Chinese exports took off after 2008, for example. The US consumer/economic actor hasn't experienced the price level effects of an easy money policy. This is a different regime. The US consumer may not have cheap Chinese imports and King Dollar passing the inflation off to foreigners as it did in the past. We believe inflation is here to stay. We think this explains the weak futures prices at the far end of the curve.

As we discussed in our preamble, vol spiked dramatically at the beginning of the month, but quickly sold off. SP vol ended up about 300Bps on the month and the VIX Index was up about 2.5 points. The most striking thing about the current situation is how quickly the indexes reversed. More than one pundit commented that it felt like 2008 again. It was like Deja Vu, all over again! Unlike the 'Great Financial Crisis' this time there was no staying power. As we mentioned in our preamble, all of the pearl clutching and clucking was for naught. We struggle to forecast what happens if/when one of these sell offs lingers for more than 3 months. The political backlash from a 401K that isn't up at least 12% might actually be more dangerous to politicians than voting against social security. It is quite the transformation. We are believers in the market process. We believe that price discovery must work for the markets to rationally dole out resources. Institutional barricades against the functioning of downward price discovery short circuit the entire market process. We have no doubt that the pressure against Powell will bear fruit. We further expect an initial rally on any interest rate cuts. However, as we discussed in the interest rate section, inflation will not wait. The situation today is very different from what existed in 1999 or 2008.

The gold phenomenon shows no signs of tapering. Futures were up 6%, but, perhaps tellingly, vol was up significantly. This is maybe the first hint that congestion is building and the top might be near. Again, we live in a period in which normality is questionable. With GDP coming in light and an easy money real estate developer in the Whitehouse lobbying for lower rates, we might see Gold blow through new highs if or when the Fed decides to cut. Extremal moves seem to be the rule, not the extreme. What is also incongruous is that platinum and palladium are both down on lower vol. One could make the argument that palladium and platinum are suffering from more electric car sales as well as a possible reduction in sanctions against the Russians. However, the rest of the industrial metals complex is mostly down. We hear news reports that Chinese copper stockpiles are at critical levels, but prices don't seem to reflect this. Vol is bid across these futures.

Wheat has continued its slide for the second month now. Its price has fallen on lower vol. The US Soy complex was higher with vol also bid on beans and meal, offered on oil. European wheat, rapeseed and corn were also down. The cattle and hogs were both higher, while their vols receded. Again, it is no stretch to argue that the sanctions drama adds in more uncertainty as we go into the early spring.

Energy goes up, energy comes down. The entire front end of the energy complex was weak. Prices fell for WTI and Brent by about 15 and 18%, respectively. Natural gas was down approximately the same. Interestingly, vol was up across the board. We are past the shoulder month for heating oil and natural gas. It is hard to pick out a factor.

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