Wheat and Inflation
With gold challenging $750 and oil quite comfortable north of $80, this young autumn trading season has already proven exceedingly exciting and profitable for commodities investors. But for students of the markets, today's price levels in the metals and energy complex are certainly not surprising. Over six years ago the fundamentals already pointed to an inevitable worldwide commodities boom.
While virtually all commodities have benefitted from this boom, as their global demand growth exceeds their global supply growth, only a few are widely followed today. Most mainstream investors monitor the oil price and most contrarian investors know the gold price as well. But far fewer could tell you the price of silver, or natural gas, or uranium, or copper on any given trading day.
Much to my shame, I am certainly guilty of this commodities myopia too. As a stock investor and speculator, I am primarily interested in commodities that are produced by publicly-traded companies that I can buy and sell. While the risks inherent in trading stocks are higher than those in trading commodities futures directly, the potential returns are much greater as well due to the inherent profits leverage of the commodities industry.
Due to this stock-centric focus, wheat has never really captured my attention. Unlike the metals and energy, there are few if any publicly-traded companies that produce wheat. And there are certainly zero junior wheat explorers. Compared to the hundreds of millions to billions of dollars it takes to open a new metals mine, the barriers to entry in wheat are nonexistent. Any farmer can choose to plant wheat any year, you don't need to float a new company to raise the capital to do it.
Although I don't have a professional interest in wheat, it still interests me academically. I grew up in wheat country and my best friend from high school is still farming wheat today. So early every morning when I work out while watching Bloomberg and CNBC, I steal a look at wheat as it crawls across the tickers. Its price has seemingly been trapped in the $3 to $4 per bushel range for decades, so I have been increasingly amazed by its persistent strength of late.
In August wheat hit $7 and then $8 soon followed in September. By early October this tasty grass was trading above $9 per bushel! About then I got a call from my old farmer friend. His bins were overflowing with a monstrously bountiful harvest, a huge blessing, and prices were at all-time nominal highs to boot. He asked me what he should do. I laughed and advised him to sell and then pay back all those government subsidies he accepted in the lean years!
By the time his hysterical guffawing ended, I unfortunately had to tell him that I had no idea. I hadn't studied wheat and didn't understand its fundamentals, technicals, or sentiment so I couldn't intelligently handicap its probabilities. But the wheat seed was planted in my mind and I knew I had to look into the stuff. Over the past month, my academic curiosity has been galvanized by wheat prices driving the prices of breads higher.
I mentioned casually tracking wheat prices during my early morning workouts. Unlike most people though, I don't drag myself into the gym to be healthy, nor to look good, nor to improve the blood flow to my brain. I work out solely to "finance" my carbohydrate addiction. I love eating, and fresh breads and pastas are the pinnacle of culinary pleasure. A meal without something in it made from wheat is uninspiring at best.
Naturally with wheat prices on fire, the prices of most foods with a material wheat component are rising as well. Even if the wheat in a particular food is not a big fraction of its total cost, the finished-food producers are using the soaring wheat prices to justify raising prices anyway. And this is where wheat gets really interesting. Since this second most-produced crop on the planet is such a food staple, it is really driving general food prices higher.
The full title of this essay is "Wheat and Inflation Expectations". As people around the world see the prices of their basic foods rise, they are really going to start thinking about inflation. Food and energy prices, since these are things we all have to buy constantly in order to survive, are the key drivers of how much the average person perceives inflation. And with the energy bull already driving basic costs of living much higher, the finally-following food prices are really going to clinch the deal on general inflation expectations.
Now a critical point must be considered here. Inflation is purely a monetary phenomenon. Per the dictionary, inflation is a "persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency". In the US, the Federal Reserve is the sole source of all true inflation. As it continues to conjure up endless amounts of new fiat-paper dollars out of thin air, relatively more money chases relatively fewer goods and services which drives up general price levels.
But any rising commodity, whether it is wheat, gold, oil, or whatever, has two key components to its price increase. True monetary inflation is the first. More dollars chasing any commodity lead to higher nominal prices. But the second supply-and-demand component is not inflation. If global demand exceeds global supply, and prices are bid higher as a result, this is a normal free-market response that would happen even if the whole world was on an ironclad gold standard with no monetary inflation.
But the key here is perceptions and expectations. When freshly-created Fed money floods into stocks or housing, everyone loves it and no one considers it inflation. But when the same new money pours into food or energy instead, everyone hates it and really starts worrying about inflation. So today's stunning wheat prices, even though they are only partially driven by true monetary inflation, will be universally perceived as purely inflationary by average people.
Every time I hear this it boggles my mind, but over the years I have read countless speeches by Fed officials where they say "inflation expectations" are the primary enemy of the Fed. You get that? The Fed doesn't fear actual inflation, as it inflates our money supply all the time with a vengeance. All the Fed fears is that people will start to perceive this inflation, and hence expect more inflation, and therefore change their spending and investing habits. The Fed's peculiar goal is to inflate constantly but not let the average person catch on!
Since everyone buys wheat products everyday to feed their families, rising wheat prices will drive general expectations of inflation like nothing else could. And following on the heels of the rises in energy prices, people are already wary of inflation. Never mind that probably 80%+ of the energy and food price increases are purely fundamental and driven by global structural deficits with only a small fraction caused by money-supply growth. People will still perceive wheat-driven food-price increases as 100% inflationary and their expectations for more "inflation" will soar.
So even if wheat isn't on your radar, its bull market will profoundly affect capital flows into other investments. The higher general inflation expectations grow, for example, the riskier general stocks will become. As all who lived through the 1970s remember, stock markets do not thrive in inflationary times. And also like in that decade, vast amounts of capital will shift into real assets like commodities and the companies that produce them. The higher inflation expectations go, the more capital will seek refuge in hard assets.
As I've pondered this over the past month, I've increasingly realized that maintaining some awareness of the wheat bull is important for all investors. How does wheat look technically? Where is it likely heading next? How does it look historically once adjusted for inflation? Is it really at its highest levels ever or is there plenty of room to run higher yet? This essay was written to address these important questions for all investors.
We'll start with the usual Zeal-format technical chart of this wheat bull to date. Now for you farmers and wheat enthusiasts, I do realize there are literally hundreds of different wheat prices. It is not fungible like gold. There are different varieties like hard red and durum, there are different seasons like spring and winter, there are different qualities and protein levels, and different delivery regions. Wheat pricing is not simple or easy.
In these charts I used US #2 grade hard-red winter traded in Kansas City. Why? Because I have the most historical data for this particular wheat benchmark. Amazingly this contract has been trading since 1876!
Back in 2000, wheat was trading under $3 per bushel and farmers were hurting. Like most other commodities, investment in wheat production had been falling for decades along with prices. And capital, which was too busy chasing tech stocks, wanted nothing to do with something as boring as growing grass. Yet out of these seeds of despair, a great bull market was stealthily being born. No price stays low forever.
Late in 2000, wheat finally surged above $3 and then started consolidating sideways. While $3.45 doesn't seem all that different from $2.75, it was still a 25% increase in price that made a big difference at such low levels. When wheat bounced along above $3 in mid-2001, it was defining a support line that would largely hold until 2004.
During this initial modestly-sloped and humble uptrend, wheat actually had a parabolic surge. In mid-2002 it blasted 76% higher between late April and early September alone. Bull to date by the top of its parabola in September 2002, wheat had already climbed 107% higher. For comparison, gold's young bull market had only climbed 26% higher by that point in time. Although it wasn't known in the gold community back then, wheat's bull was outperforming gold's bull by a whopping 4x! Who would've thought?
Following its sharp vertical surge in mid-2002, wheat was certainly due for a correction. So it contracted symmetrically in late 2002 before falling sharply to briefly hit $3 by mid-2003. But soon wheat recovered and largely consolidated sideways for a couple more years ending in late 2005. Where wheat was barely trading at $3 much of the time before its 2002 parabola, afterwards $4+ prices were quite normal. When parabolic ascents don't fully collapse, it is a major clue that real supply-and-demand fundamentals are driving the price rise.
By the end of 2005, wheat traders were very comfortable with $4 wheat and the long consolidation had driven the mid-2002 euphoria out of the market. Wheat then launched a second major uptrend, which was steeper and more aggressive than its initial one. Then this blessed source of all great breads climbed higher in an orderly fashion within this new uptrend. Soon $5 wheat was considered normal and sub-$3 was but a distant memory.
This second uptrend held perfectly until June 2007, when wheat surged above $6 in a major breakout. Now farmers, who tend to be an older lot since not a lot of young people have enough capital or interest to start in this tough business, were getting pretty excited. $6 wheat brought back fond memories of the $6 wheat briefly seen only two other times in history, back in early 1974 and mid-1996. Granted, today $6 goes a heck of lot less farther than it did one or three decades ago, but $6 is still a lot better for producers than $3.
This breakout in wheat started to get speculators and hedge funds interested in the grass game. The speculators were already plowing capital into hard commodities like the metals and energy, so why not play the softs on the side? The new all-time nominal wheat highs drove a lot of interest and wheat was bid vertically into its second major parabolic surge of its bull to date. Incredibly from April 3rd to October 1st of this year, wheat soared 89% higher! Such gains in just six months are breathtaking and dwarf pretty much everything else but the Chinese stock markets.
At its recent peak, wheat was up 262% in its bull market since early 2000. On this very same day gold achieved a new bull-to-date high too. But the Ancient Metal of Kings was only up 191% in its own bull by that point, with wheat's awesome gains outpacing it by another third. So today's wheat bull is not only real and powerful, but it even stands out among the impressive gains of its major-commodity peers.
So this leads us back to my farmer friend's question, where are wheat prices likely to head over the short term? Should he sell the wheat in his bins outright, put a floor under his wheat with puts, or wait for the grain to head even higher? This chart certainly offers some technical insights into this important question.
Whenever a price goes parabolic, rockets vertical to massive gains in a short period of time, it creates a sense of euphoria amongst its traders. So with wheat up 89% in just six months, odds are most of the capital that wants to buy wheat has already bought in. So like pretty much every other parabola before it in market history, wheat is unlikely to sustain such lofty levels in the near term. With all interested buyers likely deployed, there just aren't enough new buyers to offset selling pressure from profit-taking. So wheat is highly likely to correct here.
But the good news is a correction is radically different from a crash. Just after wheat's previous parabola of mid-2002, the grain gradually retreated and ended up stabilizing and consolidating at a level roughly halfway up its preceding parabolic ascent. Wheat surged from $3 to just over $5 then, and its consolidation in the years following centered just above $4. Our latest parabola of 2007 surged from $5 to over $9, so if wheat follows its bull-to-date precedent it will probably stabilize in the low $7s in the next year or so.
Indeed wheat has already started what looks like an early correction. But if there is one thing that mini-manias teach, it is that they are unpredictable. If we see some widely-reported supply shock that drives a bunch of wheat futures buying from capital not currently deployed in this market, wheat could still go higher yet before it corrects and consolidates. As always, only time will define an inherently unpredictable future.
So if I had wheat sitting in bins, I would buy wheat puts to lock in a floor for the next six months until spring planting. Although puts are expensive, they offer the best of both worlds by protecting farmers from downside until expiration while still allowing full upside exposure if this wheat parabola hasn't topped yet. Hedging via futures in a strong bull is risky as upside surprises are far more likely than downside ones and opportunity costs for being locked into a selling price quickly mount during a surge. Unlike futures, put options give farmers the option, but not the obligation, to sell at a certain price.
And wheat's bullish underlying fundamentals also support generally higher prices, although probably not parabolic gains. In the US, the world's third largest wheat producer after China and India, many farmers chose to plant corn this year instead of wheat. Thanks to the ethanol craze, corn has been in high demand and last autumn it looked like it would be more profitable to grow than wheat. So where moisture allowed, many farmers in the US were shifting traditional wheat acreage into corn to feed the ethanol beast.
On top of this, droughts and bad weather hammered wheat crops around the world, reducing supply. In Australia, the world's seventh largest producer, a brutal drought continues to restrict production. In this past month alone, estimates for this year's Australian wheat harvest have fallen 20%. Canada, the Ukraine, and Europe, also huge producers, have also had weather-related problems to deal with this year.
This is coupled with growing global wheat demand. Let's face it, breads taste darned good and they do wonders for the pleasure centers in our brains. As Asians start to sample the wheat-rich diet we enjoy in the West, they are demanding more wheat and their rising standard of living allows them to pay for it. Yes, carbs are like a drug and a high-carb lifestyle without moderation can cause all kinds of health problems. Regardless though, people all over the world love to eat and they will eat what they like. Wheat is high on this list.
In light of all this, wheat in the $7s seems totally reasonable to me technically and fundamentally. But is $7 wheat excessive in historical context? In order to answer this question, we need to consider the inflation-adjusted price of wheat. This next chart inflates the nominal wheat price using the US Consumer Price Index. The resulting blue line illuminates the price of wheat over the last several decades in today's 2007 dollars. It is really quite striking.
As always, the standard caveat on CPI-adjusted prices applies. I hate the CPI, as it understates true monetary inflation for political reasons. Despite this, the CPI remains the most-widely-accepted inflation gauge among mainstream investors. Using it rather than true monetary inflation makes the following chart more palatable for mainstreamers. If I had used true monetary growth instead, these prices would be much higher. Since it is designed to hide inflation rather than track it, using the CPI yields conservative numbers for constant-2007-dollar historical wheat prices.
So is $7 wheat reasonable in light of history? Definitely. In today's dollars, wheat traded at $8 way back in the early 1970s before the last vestiges of the dollar gold standard were sadly severed. $8 real was the normal wheat price back in that pre-devastating-inflation era. And then in the 1970s and early 1980s, wheat spent over a decade trading above $7 during the last commodities boom. So history has no problem at all accepting $7+ wheat in 2007 dollars.
And while wheat prices just hit all-time nominal highs, in real inflation-adjusted terms today's wheat prices aren't anywhere near all-time highs. Wheat actually briefly traded above $27 per bushel in early 1974 in constant 2007 dollars! Thankfully for bread lovers everywhere, this staggering spike was not sustainable. Since then real wheat has gradually declined on balance in a multi-decade secular bear. As the support lines above show, this real bear trend did not finally abate until 2000 or so.
But although real wheat prices are not at all out of line today for the midst of a secular commodities bull, general perceptions of wheat prices are disproportionately high. The red line above shows the nominal, the usual non-inflation-adjusted, wheat price since 1970. As my pre-research perceptions had led me to believe, wheat indeed spent most of its time between $3 or $4 per bushel. And since average people don't think in terms of real prices, $7+ wheat today has to seem really expensive compared to their historical experience.
Coming full circle, this is where I suspect this wheat bull will prove the most relevant to investors and speculators. Even though wheat prices aren't absolutely extreme, they are certainly going to feel extreme. Higher sustained wheat prices, which are likely for fundamental and technical reasons, are going to drive up food prices. Some of this will be legitimate for foods with high wheat costs, but producers will probably raise prices on foods with low wheat costs too since they can use wheat as a cover.
Higher food costs, regardless of whether they are driven by real supply and demand or true monetary inflation, are really going to stoke inflationary expectations. These expectations are the primary enemy of the Fed, because people act very differently with their money if they expect inflation than if they do not. Rising inflation expectations, partially driven by this wheat bull, are going to drive ever more capital into the hard assets which tend to thrive during inflationary times.
At Zeal we are certainly not new to this commodities game. In this bull we started buying elite commodities stocks back in 2000 near multi-decade lows. During the monstrous bull run since, we and our subscribers have earned fortunes as more and more capital has flooded into the commodities realm. This wheat bull, by raising general inflation expectations, will help spark a big new wave of mainstream capital migrating into commodities and the stocks of companies that produce them.
The biggest gains of any bull don't happen until the mainstream investors, the general public, get really excited and euphoric. More than any other commodity-specific bull since oil, this wheat bull has the potential to really wake up investors to the dangers of inflation and the great opportunities available in commodities stocks. If you want to buy in ahead of the mainstream and ride their huge capital surge higher, please subscribe to our acclaimed monthly newsletter today. With many years left to run yet, you can still multiply your own fortune.
The bottom line is this wheat bull, despite not being widely followed, should have major broader implications. People perceive inflation most in things they have to buy often, and food tops this list. With wheat-derived products being major staples worldwide, wheat is going to drive up food prices. This will really ramp up general inflation perceptions, despite government denials, and get people interested in hard assets.
And while $9 wheat may seem extreme today, it is nowhere close to being extreme yet in light of history. With strong technical and fundamental arguments suggesting $7ish wheat is sustainable in the coming year, "high" wheat prices are not going away. The longer they persist, the more they will be passed on to consumers. Thus wheat is in a unique position to drive inflation expectations higher like no other commodity ever could.
Adam Hamilton, CPA
October 12, 2007
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