Re: Oil/Macro-This Butterfly Has Big Wings.
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Re: Oil/Macro-This Butterfly Has Big Wings.
In this thread, I explain my theory on why commodity price inflation in what I call “capex/opex commodities” (vs. “store-of-value” commodities) is an ominous harbinger for risk assets.
“Capex commodities” include lumber and industrial metals that are required for building things. “Opex commodities” like food and especially energy/oil (the biggest cap-weighted commodity by far) are consumed on an ongoing basis just for human survival.
“Store-of-value” commodities like precious metals and arguably BTC have spotty correlations with real inflation. Here’s an article on why Gold is not a great inflation hedge:
The double-whammy of COVID and the equality disproportionate global monetary/fiscal response to COVID has produced a very sharp “V-bottom” for “capex/opex commodities” that are essential to economic growth.
The commodity bear market of the last 5-6 years has taken long-term STRUCTURAL supply response off-line across-the-board in these various industries. COVID just delivered the Mortal Kombat finishing move. BUT remember: the cure for low prices is low prices...
Not only is the commodity supply/demand cycle self-correcting, the massive and unprecedented monetary stimulus has flooded the world with easy money via ZIRP/QE, fueling speculative booms in stocks, real estate, crypto, art, SPACs, NFTs, etc.
FISCAL stimulus is also fueling demand in commodities by funneling checks to the lowest deciles of the wealth spectrum that spend a disproportionate amount of their paychecks on “opex” commodities. This is happening at a time when vaccines are reopening the world economy.
The combination of long-term supply destruction (years in the making and exacerbated by COVID), steep backwardated forward curves, and OPEC+ holding supply back in oil is creating very inelastic supply curves in these “capex/opex” commodities.
At the same time, monetary/fiscal stimulus + reopening of the world economy is shifting demand curves up. This combination is likely to produce some parabolic moves to the upside before this cycle is over.
Here’s the potential rub: financial assets obey a fundamental law of gravity – asset prices are inversely proportional to discount rates. And what are the components of discount rates?
Let’s go back to CAPM and remember what comprises the so-called “risky” discount rate, Rr: Rr = Rf + MRP. In words: the “risky” rate = the “risk-free” rate + the market risk premium.
I’ve been saying that certain segments of the economy seem to exhibit NEGATIVE discount rates: the further out the cash flows (the longer duration the asset) or the more negative the cash flows, the higher the prices. This is especially evident in tech stocks and crypto.
Because Rf has been artificially suppressed (pegged at ~0 on the short-end and barely above 2% on the long-end) by QE, the parabolic price moves of these “hyper-beta” risk assets imply low/negative MRPs and zero/negative discount rates (Rr).
Why is this relevant? Because commodity price inflation in “opex/capex” commodities is making the long-end of the yield curve wake up, and long-term Rf is moving higher, signifying a vote of no confidence in the Fed’s ability to reign inflation in.
If Rf continues to move higher especially at the long-end, it will not only neutralize a negative MRP, MRP’s themselves expand. Result: Rr (again, the linchpin for ALL financial assets) begins to lift.
Bottom-line: The “commodity inflation butterfly” can cause the “risk-off tsunami” via the transmission mechanism of Rr: Rr goes up -> Asset prices go down. And the asset prices MOST affected are those “hyper-beta” risk assets most dependent on low/neg Rr.
END OF ORIGINAL THREAD.
Additions here:
Inflation Butterfly is flapping its wings hard...
...and the 30-yr just decided to resume its dirt nap. Message to Fed: “Come get me. I dare you!”
The inflation butterfly is already having an effect on rates in “commodity countries” like Russia and Canada…
Lots of FinTwit angst over a chart showing slackening of “Chinese credit impulse” not explaining commodity surge. GS today: “The bullish commodity thesis is neither about Chinese speculators nor Chinese demand growth. It is about scarcity and the DM-led recovery.”
In particular, “bullish call is tied to structural undersupply, DM growth (new marginal buyer), and a global paradigm shift to ESG policies, rather than a China- centric recovery.” I quite agree.
Don’t believe the China FUD. Not only did they not collapse like DM, they are structurally SHORT almost all “opex/capex” commodities.
This is why you have to pay attention to the “Commodity Inflation Butterfly/Crucible,” particularly from the most important “opex commodity” in the world — oil. From SIS Research: “As shown in Fig II, every major US recession has been associated with some form of oil spike...”
This has been my thesis, and I’m sticking with it. Got that song “When Doves Cry” going through my head again…
I’ve been saying to expect the Overton Window to shift on tapering. From GS’ Nohshad Shah this am: “...risks around tapering are sooner rather than later. This clearly rests on good jobs data but if there are no hiccups, then a September announcement becomes my base case.”
Watch Yellen/Powell start walking back “transitory” talk just as soon as irate consumers start calling their Congresspeople.
What was a contrarian call is slowly becoming consensus.
Dead horse, I know, but this is happening folks.
Don’t conflate lumber weakness with an invalidation of the overall commodity thesis. H/T DB.
I’ve been watching bond/USD strength with some trepidation as well, although I suspect structural inflation of “opex commodities” may actually be the “crucible of pain” for the rest of the economy. Time will tell…
This trend is not your friend.
Is that bad?
Re: Oil/Macro-This Butterfly Has Big Wings.
Love these referella links which I got from your most recent article, gives the reader a chance to glimpse at these NOW historic analogs and refer to them, in hopes to develop new heuristics and future expectations - as one should do when studying Macro and markets.
ALSO, Your style of writing / persona resembles George Soros to me, in a great way, love your stuff Kaoboy, learning a crap ton !
Thank you so much for the kind words!