Sinking commodities vs. Tightening: Deflation may be early days | Insights | Bloomberg Professional Services

This analysis is by Bloomberg Intelligence Senior Macro Strategist Mike McGlone. It appeared first on the Bloomberg Terminal.

The surge in 2022 commodity prices is likely to be matched by decline of like magnitude and a long period of stagnation, based on the autocorrelation lessons of history that this year are joined by an almost unprecedented headwind: The Federal Reserve is still tightening. The central bank appears as the most critical factor for commodities, with most others, like China reopening, potentially less relevant. A key risk to broad commodities approaching March is the stock market rolling over. Facing yields of almost 5% on US Treasury two-year notes, we see potential for responsive risk-asset selling vs. buying of government bonds.

Plunging natural gas this year on the back of lumber last year may represent the early days of falling commodity dominoes.

Commodities are deflating, with plenty of economic assistance

Sinking natural gas prices in 2023 may be the poster child of what to expect in commodities when they revert from extreme premiums. Lumber did similar in 2022 and has stabilized around 2019 levels. Unless the US avoids a recession, indicated by the yield curve, broad commodities are likely to continue falling and follow the rabbits.

Commodities a body in motion lower

If the inverted futures curve is wrong and the world’s largest economy doesn’t enter a recession, commodities may stabilize near end-of-February levels. We lean toward an economic contraction worthy of the pump in prices and liquidity in 2021-22, that’s rapidly dumping at the end of February. The graphic shows the downward trajectory in commodities juxtaposed with the highest probability of recession from the yield curve since 1982. There are few factors to stop the Bloomberg Commodity Spot Index, which stretched the most in 2022 since 1974 on a 24-month basis, from reaching a typical bottom around minus 25%.

Demand from China reopening is a consensus bullish factor, but leading indicators — industrial metals and crude oil future back months — show weakness. Fed tightening may be a top pressure on prices.

Bear market bounce? Commodities vs. Natural gas

The benchmark measure of US heat, electricity and ammonia fertilizer — natural gas — has dropped to levels first traded in 1990, with implications for broad commodities, inflation and risk assets. That the Fed is still tightening in 1Q amid sharp downward trajectories in commodities reinforces our view of a severe global economic reset. The unprecedented combination of the biggest expansion of US money supply ever and Russia’s invasion of Ukraine spiked commodity prices, and our graphic shows rapid reversion.

Watch natural gas as rabbit for commodity deflation

Dropping to a low of about $2 per million BTUs in February vs. the 2022 high around $10, the US benchmark natural gas future may find responsive buyers vs. other commodities, and top notables are crude oil and corn. The Bloomberg Commodity Index Total Return appears to be starting to roll over.

‘Don’t fight the Fed’ vs. Deflating commodities

Declining commodities and the Fed still tightening in 1Q may transition into broader, more enduring deflationary forces that buoy US Treasury bonds and gold. This is our economic base case. It could be awhile before the downward trajectory of the Bloomberg Commodity Spot Index, at about minus
10% on a 12-month basis to Feb. 27, forms a foundation. Typical prerequisites for a commodity bottom is some combination of low price discounts, Fed easing, a weakening dollar and strong demand on the back of global economic growth.

Treasuries, gold could be 2023 top performers

The most central banks in history tightening is the primary headwind, and a top additional risk for commodities is if the stock market can’t sustain the 2023 bounce to Feb. 27. “Don’t fight the Fed” tilts our bias toward the downside for most risk assets.

Agriculture gains may be ephemeral

Risk that inflation and risk assets revert lower is captured by energy and industrial metals leading commodities downward in 2023, perhaps pointing to disappointing demand from China. The war premium from Russia’s invasion of Ukraine has made agriculture the top performing sector on a 12-month basis and could represent a primary threat to broad commodities. It’s typically a matter of time, notably in the grains, that high prices boost supply, and absent a poor growing season, we see the benchmark — corn — at greater risk of dropping toward $4 a bushel from $6.40 on Feb. 27.

The energy sector risks following the plunge in natural gas, particularly if inverted global yield curves are a guide for recession. Gold may have the most potential upside in 2023, notably if the Fed pivots.