A pattern is evolving in the world of inflation expectations.
It goes something like…
QE/government intervention is announced, people interpret this as inflationary, risk-on mentality ensues, a good opportunity to lock-in yield is provided for anyone who recognises the yield curve is mispriced — in the sense it is pricing in too much inflation/higher interest rates — the expectations turn out to have been misplaced, the curve corrects, confidence is lost until a new round of QE or government intervention is announced.
And so on.
This cycle has been going on since 2008, and is — if anything — only getting more pronounced.
The latest reversal to “oh dear, it looks like we were wrong about the inflation” is possibly amongst the most severe, largely because the bounce-back has involved the five-year TIP security and not just the two-year.
We haven’t got an updated version of the below chart, but compare and contrast it with the five-year TIPs response below it:
On the breakeven front, as Bank of America Merrill Lynch rightly point out on Monday, that means all the widening post QE3 looks to have been misplaced:
This break-even correction is understandably having an impact on commodities (whose odd behaviour for most of the year looks to have been an advanced indicator of what was to come).
As we’ve noted for a while, commodities are often the first clue to a curve mispricing.
It was no different this time around.
Since the beginning of the year, for example, we noted there was a strange disconnect between what the physical spot markets were telling us in terms of supply and demand and the pricing of commodity futures. Whilst there seemed to be more than enough physical supply, prices were not correcting as they might be expected to.
Part of the reason, it is now becoming clear, was linked to the incentive for these surplus inventories to be financialised (or securitised) for as long as the mispriced curve (due to incorrect inflation expectations) was in place. In that sense, high futures prices were being encouraged not necessarily by expectations of higher than expected demand for commodities in the future, but by inaccurate yield expectations.
In metals, this arguably manifested in a huge rise in both light (visible) and dark (stuff in private bonded warehouses or off-warrant) inventories.
Note the following chart from Goldman’s latest copper research note:
It’s worth noting that Goldman are now becoming more bullish because of the recent rise in “cancelled warrants”, which they say is indicative of a pick up in physical demand:
We, however, are not so sure that a rise in cancelled warrants necessarily means a rise in physical demand. Cancelled warrants can also be indicative of LME metal being used as collateral for securitised deals held “off market”, at least until the price rises enough to encourage the inventories to be liquidated.
The same mispricing will also likely have affected oil.
For example, it’s worth noting the Russians were very active in the world of prepaid supply this last quarter. Such deals could only have gone through if there were clear incentives for upfront payments to be made.
Indeed, from a financier’s point of view, a mispriced commodities curve would have offered a huge incentive to buy yet-to-be produced oil (especially since it comes without storage cost) today because it could be hedged in a way which effectively replicated a yield bearing security. And most likely one whose yield beat any equivalent “safe” or fully collateralised deal on the market.
It’s no surprise that the Brent curve (where the bulk of the hedging would have been done, even for Urals grade which usually trades at a discount to Brent) had a burst of backwardation at the end of last year in response:
The recent (and fleeting) contango could well be spot Brent’s adjustment to these now (over-)committed supplies in the face of suddenly muted inflation expectations.
Not that any contango is likely to last for long, since the curve formation only incentivises either more financialisation/securitisation (which itself leads to backwardation) or leads to production shutdowns (and bankruptcies) which are intended to lift prices beyond that magical $100 dollar breakeven rate.
It’s also worth noting there was also no significant geopolitical tension story this time around to keep prices supported in the first quarter. Though we do, as of last week, have a somewhat price supportive force majeure declared by Shell on Bonny oil exports out of Nigeria.
Now, for something to revive inflation expectations more widely in the financial markets?
Related links:
Confused curve signals – FT Alphaville
The negative carry universe - FT Alphaville
Pariah profits in an age of ‘negative carry’ - FT Alphaville
Have the inflation-paranoid capitulated? – FT Alphaville