This article is the view of the wildlings in the forest on how to trade futures in the period of commodity inflation in 2021.
There are many views and theories circulating in the media about the nature, origin and duration of the current inflation spike, and everyone analyzes the inflation threat from a different perspective.
In commodity futures trading, it is important to distinguish between the types of inflation that are happening.
To take advantage of monetary inflation, you must constantly focus on certain fundamental indicators and markets to predict the inflationary turn of the market.
The root cause of the divergence over inflation is whether inflation is temporary or long-term.
If you pay enough attention to it, you may find that the inflation discussion has split into different factions. Some people think it's a supply chain issue. Some people think it's a currency issue. Some say neither matters unless the printing rate is accelerated.
But one thing is certain, and that's that the whole debate relies on one thing: Will inflation be a "temporary" phenomenon?
Commodity inflation in 2021
To get a clearer picture of where we are now, let's look at the following diagram first. This chart is featuring Bloomberg Commodity Index Futures (Black), Deutsche Bank Agricultural Fund (green), Deutsche Bank Base Metals Fund (blue), Silver Futures (grey), Copper Futures (Red), Gold Futures (Gold) for 2014-2021
The Bloomberg Commodity Index is an energy-weighted index, and we know that energy prices have been falling for years and didn't pick up until 2020, as economies began to work to accelerate recovery due to money printing and fiscal stimulus.
Deutsche Bank's Agricultural Fund, particularly in the U.S., also saw its agricultural products fall until the pandemic disrupted the flow of supply chains. With the shortage, so did the price.
Now this is where it gets interesting. Please note the Deutsche Bank Base Metals Fund. It began to rise in 2016. Two years later, copper prices fell back and didn't soar until 2020, when, like all other commodities during the pandemic, copper nearly outpaced most other commodities.
In 2019, the spread between silver and gold widened, and although gold's gains exceeded all of the above commodities, silver's gains were significantly greater.
The main point here is that we are looking at the "inflationary effect" caused by different factors (supply chain and monetary factors).
What is the relationship between inflation and commodity prices?
There are generally three forms of inflation:
Demand-driven: When demand for certain goods and services exceeds their supply (e.g., supply chain disruption).
Cost-driven: When production costs shift to consumer costs (for example, we also see copper prices, construction material costs, and other commodity-driven "input costs" entering product markets today).
Intrinsic: When the total cost of living leads to an increase in wages (mainly a "monetary" issue).
The relationship between commodity prices and any supply chain disruptions that can hinder delivery when demand is high is straightforward. Supply chain-related inflation is often unpredictable.
Monetary inflation is another matter. Some economists would argue that inflation starts at the level of the money supply, and that the expansion of the money supply and inflation will eventually make it an upward point in the cost of goods and services.
Other economists argue that it's not so much the money supply as it is about "printing money." Which commodities best cope with this inflation? That's what I'm going to say next.
Gold and silver are the most advantageous assets in times of monetary inflation
When people talk about inflation, they usually refer to long-term monetary inflation that stems from monetary or even fiscal policy. Specifically, printing money and fiscal spending reduce the value of money, and the over-issuance of government bonds crushes purchasing power.
As you probably know, one of the most traditional inflation hedging tools is gold and silver, both of which supported the dollar when it was pegged to the gold standard.
Gold – High currency security
Gold is at least 2,000 years old and is one of the most valuable monetary assets since the birth of civilization.
In countries around the world, gold may not be considered a "fiat currency" asset, but it is still considered a "prudent currency".
The point is that gold is still money. Because of this, gold remains the best safe haven against inflation.
So, what does the trend of gold tell us before and after the epidemic?
Gold's rally began long before the outbreak. After a series of rate hikes, the Fed promised to stop raising rates in December 2018. Note that the Fed has been heavily criticized by former U.S. President Donald Trump, who has repeatedly and publicly pressured the Fed to lower interest rates to stimulate economic growth.
In August 2019, the Fed cut interest rates to 2.25% despite economic growth. Gold broke through 1377 points, showing a clear upward trend, and monetary policy is expected to be further relaxed.
In March 2020, the Fed responded to the lockdown of the outbreak by cutting interest rates to 0.25%, effectively zero. The price of gold continued its upward trend, reaching $2089 an ounce before retreating.
For now, with Fed interest rates still close to zero, safe-seeking investors are flocking to gold as a potential hedge in case the so-called "transient" inflation spike proves to be a higher, longer-term and systemic problem.
Silver = currency + industrial use + renewable energy metal
Silver occupies a unique position. It is certainly a precious metal, but also a monetary metal, just like gold. But it is also an industrial metal that is now a key component in the development of solar and other renewable energy technologies.
Here are the things you should know, whether you're a short-term trader, a long-term investor, or whether you just want to hedge your portfolio: According to a study by the Silver Institute, demand for silver in print and electronic materials has soared from less than 10 million ounces in 2010 to a staggering 48 million ounces in 2020.
Seeing the growth in demand for silver, you might ask how much of this surge is due to the demand for money, silver is a mixture of hedging inflation and industrial demand, which is why silver is a unique commodity.
Is your portfolio inflation-ready?
There are many ways to diversify your portfolio to hedge against inflation risk.
Gold and silver are two commodities that hedge against inflation. When one rises, the other is likely to decline over time.
Harry Brown's perpetual portfolio theory is a popular all-weather investment model. The formula is simple: 25% stocks, 25% long-term Treasuries, 25% cash, and 25% precious metals.
The main commodities here are "prudent currencies" – in short, gold and silver.
When inflation plagues the economy, the value of fiat money declines. The cost of goods and services is rising.
Stocks may outpace inflation, but it depends on whether companies can sustain or increase revenue and earnings, as well as transparency in public companies.
What about bonds? Any fixed income can be eroded by inflation. It can also be overwhelmed by inflation.
Therefore, gold and silver medals are the only remaining tools in this combination. They are not "perfect", but again, you may have other "monetary" goods. Other physical commodities may also rise, but as the Bloomberg Commodity Index and the Agricultural Index (DBA) show above, they lag far behind gold, silver and copper.
How can I profit from inflation?
I want to limit this discussion to monetary inflation, not to any inflationary effects due to supply disruptions. The reason is that sudden supply shocks are often unpredictable. If a supply disruption indicates a long-term problem, then you have to understand the fundamentals that are driving price spikes.
Now, if you want to profit from monetary inflation, say, by investing in gold and silver, the rule is to focus on the big picture.
m1 money supply
Precious metals trading would have followed the m1 money supply. Some people think that inflation is a monetary phenomenon. In particular, some theories point out that money supply inflation is the biggest inflation predictor in the economy.
For example, in 2020, about 20% of the dollar was created. See the m1 chart? Can you see how this has propelled gold and silver prices to skyrocket, with gold reaching record highs before pulling back?
Producer Price Index (2009-2021)
Are you paying attention to the producer price index (ppi)? Higher input costs typically reduce producer revenues. Often, when input costs continue to rise, producers often raise prices to help cover the cost of goods and services. In April, the US PPI rose 6.2% year-on-year, the highest PPI increase since 2009.
Consumer Price Index (1947-2021)
If you look at the U.S. CPI from 1950 onwards, you can see a slow and sustained decline in the purchasing power of the dollar. But let's take a look at CPI and what it stands for today.
Consumer Price Index (2018-2021)
The impact of monetary inflation on consumer goods and services should be quite pronounced. If you pay attention to the current CPI report, inflation surged 4.2% year-on-year in April, the biggest increase in CPI since September 2008.
epilogue
A bullish trend in commodities may have already begun and gain momentum in 2021.
But the link between commodities and inflation will vary depending on the type of commodity and inflation. So, if you want to use futures to hedge against inflation, the only viable strategy is to focus on the big picture and strictly implement your trading plan.