Canada Markets

Everyone is affected by inflation, like it or not. And likely everyone is affected by increased interest rates -- either through higher borrowing costs or added income.

Those in the latter group must be concerned about the real rate of return (rate received less the inflation rate). Wealthy investors contributed to the greatest rally of the past decade trying to protect that real rate of return by buying commodities as a hedge against inflation.

Given how successful it was for them previously and that current developments suggest the same is happening again, I feel it's important to revisit the topic and update developments. So far, corn has already benefited with indications wheat could be next -- but more on that later.

On Feb. 12, the January consumer price index (CPI) update surprised market participants by being much hotter than expected. Headline CPI came in at 3.0% on an annual basis versus 2.9% expected and the prior month. Core CPI (less volatile food and energy) was even more concerning at 3.3% versus 3.1% expected and 3.2% last month. Not that the figures are that outrageous, but as evident in the accompanying chart they are quite concerning in pattern. The fact that they were also from the final pre-tariff period, with it nearly universally accepted that tariffs will be inflationary to some extent, came as comfort to no one.

On Feb. 13, the January producer price index (PPI) update was no better. It not only came out higher than expected, but December's data was revised higher. Headline PPI came out at 3.5% on an annual basis versus 3.2% expected and a revised 3.5% for the previous month. Core PPI had a similar outcome, reported at 3.6% on an annual basis versus 3.3% expected.

The fear stirred by the upturn in inflation indicators is a repeat of the 1970s cycle when an apparent taming of inflation was followed by a much more problematic acceleration. As many would recall, the crushing interest rate increase required to bring it back under control had serious ramifications.

Such fears have resulted in investors demanding higher long-term interest rates (achieved through lower Treasury prices) at a time when the U.S. Federal Reserve was cutting its overnight target rate. The U.S. 10-year note went from 3.64% the day the Fed kicked off the current cutting cycle to a high of 4.80% in early January. By that time the Fed had cut the overnight target rate by 1%. The market seemingly assumed that lower short-term rates would be long-term inflationary.

What appeared to be a bear market correction took Treasury prices higher through to Feb. 7, resulting in the U.S. 10-year note falling to a low of 4.40%. An inflationary payroll report and surprisingly hot "University of Michigan -- one year inflation expectation" report marked an end to the rally, setting the stage for this week's higher-than-expected CPI and PPI reports with the U.S. 10-year note reaching 4.65% Wednesday.

Looking forward, political considerations don't help (keeping in mind this is in no way political, simply pointing out facts). President Donald Trump's plans are likely to add to inflationary pressure if enacted as promised.

Tariffs are almost certainly inflationary, especially given the wide scope, with the debate being over their long-term impact or simply a one-time bump. Wage inflation could be hard to avoid should there be mass deportations as promised. Extending tax cuts would theoretically add to disposable income and thus inflation. And finally, a Federal Reserve that could lose its independence could also have limited ability to maintain interest rates high enough to limit inflationary pressures. That notion has been downplayed by everyone so far in the new term but the morning of the hotter-than-expected CPI print, Trump was again demanding the Fed lower interest rates.

If we do see an acceleration in inflation, it's hard to imagine energy and food not taking part. The greatest advances in taming the recent spike came through negative goods inflation while it was the services inflation that was sticky and prevented a return to the 2% target.

The Oct. 30 blog on crude oil laid out an increasingly possible scenario where Middle East tensions resulted in an energy price spike given the low Strategic Petroleum Reserve levels. The latest suggestion by President Trump that the U.S. would prevent Iran from developing nuclear weapons "at all costs" was followed by sanctions against anyone aiding in Iran's oil exports. Potentially destabilizing could also be Trump's plan to take over Gaza in exchange for rebuilding it -- irritating most nations in the region, including Saudi Arabia.

Corn prices have already responded to the limited supplies found in the world's major exporting countries (as covered in https://www.dtnpf.com/…). Commodity Index Traders (CIT) added to the rally seen during the past five months, taking their net-long position in corn from 214,206 contracts in August to 479,902 as of Feb. 4. That buying of 265,696 net contracts or 1.328 billion bushels certainly contributed to the $1+/bushel gain. And an excellent example of why we follow these sorts of things.

Back to why this might be important for the wheat markets. So far, the CIT group has avoided wheat as a hedge against inflation, leaving managed money traders to continue testing low price levels. That may finally be changing for both. CIT net-long positions in Chicago wheat were recently the lowest seen since reporting began in 2006, at 51,235 contracts as of Jan. 27 (the record high was 166,210 contracts set in early 2022). With prices just $0.60/bushel off multi-year lows but $7.10/bushel off 2022 highs, it is a prime candidate for a hedge against inflation.

The fact that managed money traders still hold a very large net-short position adds to the upside price potential. Between Chicago and Kansas wheat, they were net short 126,423 contracts or 632 million bushels as of Feb. 4. They had already started covering their short positions going into the Tuesday cutoff so momentum suggests more of the same may be expected ahead.

So, what does that mean for management and marketing decisions? Refreshing your 1970s history lesson would be a good start. Being aware of the potential for increased prices when developing marketing plans and being on the lookout for triggers. It may also be wise to keep an open mind about prices increasing for no apparent reason as outside investors buy commodities as a hedge against inflation (more on that another day). And unfortunately, considering the impact higher interest rates may have on the operation should a repeat of that part of the cycle be seen -- along with strategies on how to mitigate the impact.
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My daily comments can be found in Plains, Prairies Opening Comments and Plains, Prairies Quick Takes. I'm always happy to get feedback along with any suggestions for future blogs.

Mitch Miller can be reached at mitchmiller.dtn@gmail.com

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