Post Fed Meeting Unwind of Many Crowded Inflation/Commodity Trades

Yesterday, the Federal Reserve meeting concluded with a message that they are monitoring many of the rising costs and the Inflation pressures in parts of the economy, and that there is a plan to reduce accommodative asset purchases and raise interest rates some time in the next two years.  We are seeing a sharp selloff in the commodity sector and a bounce in the U.S. dollar this morning.  The chart below shows the crowded inflation trades… and the top three categories are declining this morning.

We suspect the reaction is partially due to what the Fed said, but the slide in metals is also driven by recent moves in China to halt runaway commodity prices through various liquidity restricting measures. 

The large upward move in metals, lumber, and food prices during the first few months of 2021 caused a tremendous bullish inflation trade.  A lot of money plowed into these areas for reasons we have discussed.  Perhaps too much, because it caught the attention of the leadership in China.  Because of China’s ability to rapidly pivot their inventory-building and monetary policy, it is possible that that move is over for a while.

We have been looking for opportunities to add to commodities on dips.  Right now, there could be more downside as this inflation trade, which Bank of America Merrill Lynch called “crowded,” is unwound. 

Inflation

We are of the opinion that while inflation data will still show large year-over-year increases for the next few months, the month-to-month numbers ahead will likely show a deceleration.  There is still underlying inflationary momentum in different sectors, but some areas like lumber prices, the prices of used cars, semiconductors, industrial metals, and other assets looks to have cooled.  Business inventories are a key indicator of future inflation, and they are low.  Businesses need inventories in order to make sales.  Supply chains have been badly disorganized as a result of covid, shipping problems, and crowding at ports.  As these dislocations are remediated, pricing pressures should cool off.  This has been the Fed’s view.

Is the commodity inflation trade over? Or is this a needed correction before another leg higher?  As we mentioned above, we are watching China and the other policymakers as closely as we are watching the price movements.  As we mentioned above, if the Fed is right about the transitory nature of the current inflation, then the run in commodities could be over, and they could once again go back to being a frustrating investment allocation.  If the Fed has it wrong, and inflation persists for longer, then investors and traders should welcome the current slide, as uncomfortable as it may be this morning.

Bonds

We agree with Jamie Dimon, the CEO of JPMorgan, who says they are holding half a trillion dollars in cash that would normally be invested in Bonds, waiting for higher interest rates, which will occur in the future.  We agree with them that the Federal Reserve’s purchasing of mortgage bonds and other bonds at the market has greatly dislocated rational pricing in the bond market, and we expect bonds to fall in price.

Thanks for listening; we welcome your calls and questions.