The commodity bull cycle is back, with Ag and energy prices the highest levels they have been since 2013, save for the post-pandemic booms.
This great news for traders and energy companies — but potentially bad news for the rest of the global economy. The current bull market is in late innings, running off the fumes from prolonged low interest rates. The hopes of ever-expanding profit margins driven by artificial intelligence has delivered a can of economic Red Bull, but no party lasts forever.
To understand the current economic landscape and potential paths forward, it is critical to understand the relationships between commodity prices and inflation, and inflation to interest rates. The commodity rally can be summed up in one simple bullet - the war in Iran is driving crude oil prices, and other commodities are getting pulled along for the ride. Commodity prices are driven by supply and demand, and crude oil right now is facing pressure on both fronts. Demand remains strong as the global economy is humming, meanwhile supply is significantly constrained both by infrastructure damage and by the shipping bottleneck in the Straight of Hormuz. Plenty of smart analysts think crude oil should be trading closer to $150/barrel right now, but the global markets are predicting the war will simmer down, keeping prices closer to $100.
Ag commodities are also rallying, in part due to correlations with crude oil driven by renewable fuels markets. In short, when crude oil rallies, ethanol and renewable diesel also rally, which sets off increasing demand for corn and soybeans as feedstocks for those renewable fuels. When hedge funds become bullish on commodity prices, they often elect to buy a basket of many commodities, and this buying then drives up futures prices for other ag commodities as well as metals. Ags are also getting more traditional fundamental support from a few sources. U.S. crop production estimates are declining as weather has impacted the current crop, particularly with flooding in the Corn belt. The Ukraine/Russian war continues to constrain wheat supplies, and recent trade talks with China appear supportive of China making some big purchases of our U.S. crops. If this all seems very confusing, just remember one point — rallying commodity prices are currently they most important component of stubborn inflation.
Let's now pivot to briefly unpack the relationship between inflation and interest rates. The Federal Reserve, regardless of who is in charge, has two main mandates. They want low unemployment, and they want to keep prices rising at a healthy rate of no more than 2% annually. They balance these goals by turning the dial on interest rates. Since the global financial crisis, they kept interest rates as low as possible, which juices the economy and creates jobs, but eventually can also lead to inflation. As the pandemic snarled supply chains and drove inflation over 6%, the FED was forced to turn the rate dial the other direction, attempting to slow the economy and tame inflation. That plan, the brainchild of Jerome Powel, was working slowly but surely, until the war in Iran ruined everything. Headline inflation is still stuck at 3.4%, much higher than "core" inflation which removes energy and sits around 2.4%. It is the former number of 3.4% that the FED wants to push back down towards the 2% mandate, and to support that directional move, they increased interest rates by .25% in September - the first such increase since 2023.
So what happens next for the global economy? It appears likely we will face several more rate hikes in the next 12 months, and those hikes do act to pump the brakes on GDP and tick unemployment higher — it is a delicate game. If the war continues and crude oil stays elevated or moves significantly higher, rates would then move higher yet potentially tipping us into a recession. It is important to note we are starting from a fairly solid position of broad global growth, along with Ai tailwinds. That means the economy can absorb some small rate hikes, but "higher for longer" will eventually bring economic pain.
There is one more wrinkle to consider briefly, and that is the enormous 30 trillion-dollar debt the U.S. government has racked up. Portions of that debt are constantly coming due and must be "refinanced" with new bonds, and in the bearish scenario of high oil prices and high interest rates, those new bonds carry higher interest payments. It can become a runaway train in a hurry. To be clear, the "base case" economic forecast almost never predicts a significant recession - it's only in hindsight that it looks obvious. That said, the percentage chance of a recession in the next 18 months is ticking higher by the day. Hope for the best, but be prepared.
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