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  • Writer's picturePatrick Ling

Are Commodities in a Sweet Zone?

Some market participants believe in the peak inflation narrative. Looking at the price chart of the CRB Index, it is understandable why that is the case. For those who might not have heard of this index, the CRB Index is calculated using the arithmetic average of commodity futures prices with monthly rebalancing. The index consists of 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, RBOB Gasoline, Silver, Soybeans, Sugar and Wheat. Those commodities are sorted into 4 groups, with different weightings: Energy: 39%, Agriculture: 41%, Precious Metals: 7%, Base/Industrial Metals: 13%.

CRB Index
Source: Trading Economics

However, this peak inflation narrative doesn't square with the fact that the Fed Funds rate is still way below the current CPI. Even if the Fed raises the Fed Funds rate by another 75bp in the next FOMC meeting, the gap would still be more than 4% wide.

CPI vs Fed Funds rate
CPI y/y is significantly higher than Fed Funds rate

It is dangerous to stick to a narrative without constantly monitoring the assumptions supporting the narrative. The CRB Index has been trending up recently. This should at least call into question whether inflation has indeed peaked.

The market is always talking to us by way of prices. Between listening to opinions and looking at market prices, the latter should always be more reliable. As the saying goes, "look at what people are doing, not what they are saying". Prices represent the aggregate action of market participants.

Since the beginning of this year, almost all asset prices are down while major commodities are up. The market could be suggesting that commodities are in something of a sweet spot.

If the Fed backtracks on the tough stance toward fighting inflation, it is a green light for commodities to move up. If the Fed sticks to the market expectation of a 50bp or even 75bp hike in September, the Fed Funds rate remains significantly below CPI and commodities should remain supported.

The downside risk to commodities is if CPI drops significantly or the Fed is even tougher than what the market expects.

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