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While policymakers are focused on deflation, many investors are worried about inflation. This can be seen in bond markets – US 10-year Treasury yields have risen by 29 basis points since the US Federal Reserve officially embarked on quantitative easing. It can also be seen in commodity prices – over the past week, the benchmark S&P GSCI has risen 7 per cent. As real assets, commodities can offer the prospect of a better hedge against rising prices than the usual inflation-indexed bonds. But anyone looking for inflation insurance from commodities may need to think again.
The reason is the prohibitive cost. Investors have a choice. They can buy the physical commodity – but where to store it? Keynes once measured out the chapel at King’s College to see if it could hold a huge speculative wheat position he had accumulated. Alternatively, investors can take financial ownership through the futures market. Yet storage costs are a factor here too, and these have soared lately because silos are brimming with supplies. That is why future prices are now far higher than current prices. In the jargon, commodities are in contango.
The best example is oil, the most liquid commodities market, and therefore the best suited to inflation hedging. An investor buys the front month contract. But when it expires, he has to buy the more expensive one next month. The cost of this roll is about $1.60, or $19 annually. To cover this “insurance premium”, oil prices would have to rise 36 per cent. That is a bet, not an insurance policy.
An alternative is to buy futures that are further out, say in two years’ time. That makes more sense as inflation is tomorrow’s problem rather than today’s. It is also potentially cheaper as the contango is less steep. The monthly roll is about 30 cents a barrel, so oil prices would have to rise by “only” 5 per cent to cover that cost. The trouble is that futures are more illiquid further out, so hedging becomes harder. And there is always the risk that commodity prices might fall. The risk committee would have something to say about that.
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