These two terms are used to describe whether a commodity is being priced higher due to supply issues, or demand, and in simple terms this is how it works.
If the price of corn is in backwardation this means that the futures contract closest to expiry is priced higher than one expiring at a later date. In other words, backwardation creates a
downwards sloping price curve.
Backwardation tells the market that there is a short term supply issue which in the case of corn could be a weather related issue.
The opposite of this is contango. This is when futures commodity prices are higher than the closest futures contract. In other words the price at a later date is higher than the current price.
This is a normal market condition, and therefore a demand led price rise. Therefore, results in an upwards sloping price curve.
This is how we tell the difference between a supply led price increase and a demand led price increase, of which the latter is signalling inflation and the former is not.
Before we move on to look at bonds in the context of inflation let’s just look at the three
different types of inflation and how they occur in practice. These are referred to as:
1. Demand pull 2. Cost push 3. Imported
Demand pull is the example we looked at above with corn, where demand from the market is increasing the price of the commodity.
Cost push occurs most often when salaries and wages begin to rise along with other costs of production, and this is the second clear sign of inflation.
Finally, we have imported inflation which occurs as the result of a weak currency exchange, which may be good news for exports but not good news for net importers of goods, which increases costs driving inflation into the economy.
With the last of these, perhaps you can begin to see why as a currency trader you have to understand all these linkages and economic factors which ultimately drive the markets in their endless and often repeated cycles. So, is inflation a good thing or a bad thing? And the answer, of course, is that it depends!
Inflation is fine as long as it is under control and, if so then it can be considered to be positive for the economy, as business expands and creates jobs at a measured pace. However, once inflation starts to rise and run out of control, then it becomes a bad thing, interest rates begin to rise causing the economy to slow and jobs are lost.
I will look at inflation in more detail in a later chapter, as well as its cousin, deflation.
But what about bonds as a measure of future inflation? If you remember in the chapter on bonds and bond yields, a bond has two elements. The underlying price of the bond, and the bond yield. As the price goes up then the yield falls, and as the price of the bond falls then the yield rises.
However, now let us look at a bond from an issuers point of view and assume we are a
government or municipal authority who want to raise some capital for a project. We decide to issue a bond, but at what interest rate or coupon?
The first consideration is we are in competition with other organisations who also want to attract money, so we have to offer a competitive rate. For the purposes of this exercise let’s assume the general borrowing rate for lending is ten percent and we decide to issue a bond with a borrowing rate of fifteen percent.
In this scenario it is not difficult to imagine there would be a queue of investors at the door desperate for this bond as we are offering a rate which is significantly higher than our competitors.
This would ensure we received our capital, but at a very high price and not in line with market rates. Equally, if we offered the bond at 5% we would have no one buying the bond. Therefore, bonds reflect market rates. They have to, otherwise no one would be interested in them.
However, back to our example. As a lender we also have to keep an eye on the economy, inflation expectations and therefore interest rates. If we believe that interest rates are likely to rise in the future, either in the short term or indeed the longer term then this has to be factored into the coupon rate of the bond. This is what every other bond issuer will also be considering.
If we all think that inflation is likely, then our coupon rates will rise, as will yields, which will then be reflected in the yield curve that we looked at in the chapter on bonds.
As I pointed out when we looked at commodities, rising yields are not necessarily a bad thing.
We can often see the yield curve rising due to future inflation along with both commodities and equities, two risk asset classes. Rising yields and rising inflation can therefore be a positive signal of a strong economy and solid growth.
In this scenario rising yields will also be helped by the flow of money out of low risk
conservative bonds, and into higher risk commodities and equities, so in any analysis of yields, we need to be careful to consider both reasons for increasing yields. Namely, is this an
inflation led yield increase or a risk led increase with investors looking for higher returns, in higher risk assets, and away from bonds.
At some point, of course, investors will start to look at bonds as a better and lower risk investment than commodities or indeed equities, with a consequent flow of money into conservative bonds.
The question is where, and how, do we look for the clues and signals for such a flow of money, at this so called tipping point.
Unfortunately, there are no hard and fast rules. If it were that easy we would all be millionaires by now. However, as a rule of thumb, it is once yields on the ten year US treasury note reach 5% and beyond. Historically this has become the tipping point at which investors begin to consider moving money away from risk assets, such as commodities and equities and into safer assets such as bonds, and the question, as always, is why.
And for for answer we have to go back to inflation and it is very straightforward.
The early stages of rising yields generally reflects an improving economic picture with relatively low inflation which is favourable for riskier assets such as commodities and equities.
However as bond yields rise above 5%, economic growth is accompanied by higher inflation, which is likely to threaten future growth, erode the value of future earnings and act as a drag on equities. The net result is an outflow of money from high risk assets into low risk assets,
namely away from commodities and into bonds.
Whilst the bond commodity linkage can be difficult to understand it is an important one as it reveals so much about future inflation expectations and interest rates. For forex traders it can provide valuable insights into central bank thinking and future exchange rate decisions.