When These 'Inflation Traders' Talk, It Pays To Listen

Authored by Simon White, Bloomberg macro strategist,

Commodity inflows are rapidly increasing, a reliable sign of rising prices in the sector. More importantly, it’s also a harbinger of inflation on the threshold of re-accelerating.

Inflation is over. Well, that would be the conclusion you’d draw from the Federal Reserve’s action yesterday, cutting rates despite unrestrictive financial conditions and an economy in no immediate danger. It’d also be what you surmise from falling bond yields and stocks at all-time highs.

But pay attention to the part of the market telling a different story. Inflows into commodities have been rising for most of this year and at an accelerating pace, with that also seen ahead of inflation’s rapid ascents in 2020/21 and 2009. This is a message it would be wise not to ignore.

Why listen to the commodity market?

It is much closer to inflation than other markets, with rises in raw materials prices typically the precursor to much broader increases.

Commodity inflation quickly bleeds into the manufacturing and industrial sectors, and then into higher input prices of upstream firms. Before long, goods prices in general are rising, generating wage pressure and pushing up services prices too. It’s thus no surprise we see the relationship in the chart below, with metals prices leading global CPI by about 6-9 months.

As we can see, the rise in metals prices this year is a warning that inflation is soon about to do likewise. Commodity investors, you’d wager, are on to something.

Oil has been the biggest drag on the commodity complex, with the market beset by oversupply. But stimulus in China is finally beginning to gain traction and could soon see crude turn a corner. Acceleration in real money growth typically leads increases in the growth of oil prices by 3-6 months.

Gold has lately been stealing the limelight, but the pick-up in commodity inflows is broad based. Gold ETFs are among the largest commodity ETFs, and inflows have been rising. But taking out gold and precious metals ETFs from the total still leaves the clear message that commodity inflows are unequivocally rising, and doing so at a faster rate.

The surprisingly gradual pace of inflows to US gold ETFs — especially so given the steady ascent in the price — is a reflection of the rest of the market’s complacency on inflation. The same has been the case in Europe. It’s only in Asia where, until very recently, zeal for gold among ETF buyers betrayed any inflation or financial-stability angst.

Inflation over-confidence can also be seen in stocks and bonds. Inflows into the largest stock and bond ETFs in the US are at or near highs, and are showing no notable signs of decline.

In the inflation-ridden 1970s, the worst performing main asset classes were stocks, corporate bonds and Treasuries respectively. Stock and bond inflows are not reflective of a market expecting anything similar to that period. Then, inflation rose sharply before falling back to a higher low and re-accelerating to make a new high at the beginning of the next decade. Commodities were the only asset class to provide a significantly positive real return in the 70s.

TIPS was the only other main asset class to have an above-zero real return in that decade (using a synthetically calculated real yield to mimic how TIPS may have performed). Today, inflows into inflation-protected bonds have been rising, but at a pace bereft of panic or anxious concern.

Moreover, call skew in the TIP ETF is zero. This rose sharply ahead of the inflation jump in 2021 and the tumble in real yields. TIPS traders do not appear to be reading the same script as commodities investors.

As alluded to earlier, commodity traders are likely basing their view on where commodities are going – inflation just tends to follow suit. This time is no different, with inflation leading indicators banging the drum ever louder that price pressures are about to accelerate.

My inflation leading indicator — a combination of manufacturing, money and commodity data — has steadfastly remained above 2% over the last past few years, and is now rising at a quickening pace. It leads CPI by about 3-6 months.

Other inflation-leading indicators are dancing the same dance. Freight prices are rising, and so too are fertilizer prices, which lead food CPI. Inflation expectations are also increasing.

Most worryingly for the Fed (or at least it would be if it still practiced monetary independence) is that acyclical inflation is rising. This comprises the components of core PCE least correlated to monetary policy, and therefore most out of the Fed’s direct grasp.

If it turns out commodity investors are correct in their view, they could be in line for a bumper pay day, with Bloomberg’s Commodity Index returning 130% in 2020-22 as inflation was rising.

Yet the rise could be even be more significant. A re-accleration in inflation might cause the penny to drop in the rest of the market that price growth is not a one-shot problem. Holders of financial assets may then realize they need an inflation hedge. It would only take a pint-sized re-allocation from stocks and bonds to overwhelm traded commodity markets and squeeze prices much higher.

The Fed has set out its stall, cutting rates at probably one of the most inappropriate times in its modern history. Stocks and bonds are blasé about the risks to real returns. But commodities only tend to speak when they have something to say. This looks to be one of those times.