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This Leading Indicator Is Higher and Could Point to a Bottom

Barchart - Sun Oct 16, 2022
Lumber - Lumber - marissa-daeger-iW9iaL-gjX8-unsplash

The CME is replacing its current random-length lumber futures contract with a more flexible, physical lumber futures contract. The new contract is smaller, with a 27,500 board feet contract size, compared to the old contract calling for 110,000 board feet. Moreover, a truckload instead of a railcar full of wood can fulfill the new contract. In a September 17 article on Barchart, I outline the differences, pointing out that the new contract has yet to gain the critical mass necessary to build liquidity. As of October 14, the physical lumber contract has not attracted the volume and open interest levels of the old random-length lumber contract. 

Before 2018, random-length lumber futures had never traded above $493.50 per 1,000 board feet, the March 1993 high. Lumber rose above that price in 2018, reaching a record $1,711.20 record high in May 2021. This year, lumber futures made a lower high at the $1,477.40 level before cascading lower to just above $400 per 1,000 board feet in September. Lumber futures remained below the $500 level on October 14. 

A selloff from a lower high

Lumber futures dropped 72.7% from the March 2022 high to the September 2022 low. The six-month decline occurred as selling overwhelmed buying in the lumber market.

The chart highlights the correction, which fell below the August 2021 technical support level at $448 per 1,000 board feet. The price dropped to $402.80 in September before bouncing to just under the $500 level in October. The nearby November contract was above the $480 level on Friday, October 14.  

Rising interest rates weigh on wood’s price

On Thursday, October 13, the September CPI data came in hot as inflation increased by a more-than-expected 0.4%, reflecting an 8.2% increase in consumer prices over the past year. Core inflation, excluding food and energy, the CPI accelerated 0.6%, a 6.6% increase since last year, the highest rise since August 1982. The CPI could set the stage for the fourth consecutive 75 basis point Fed Funds Rate hike when the FOMC meets on November 1-2. Another 75 basis points on the upside will put the short-term Fed Funds Rate at 3.75% to 4.00%, an incredible jump considering it was at zero to 25 basis points in March 2022. 

Meanwhile, conventional fixed-rate 30-Year residential mortgage rates below 3% in late 2021 were sitting near the 7% level on October 14. A 4% rise in home mortgage rates increases the monthly payment on a $400,000 mortgage by a staggering $1,333.33, stifling the demand for new homes. Since lumber is a critical input in new home building, the explosive move in interest rates has caused a slump in the residential construction market, weighing on lumber demand. Rising interest rates have pushed lumber prices back below the pre-2018 record high.  

The physical contract’s premium over the old contract

Since lumber is a benchmark better suited for watching than trading or investing, the price differential between the new physical and old random-length lumber futures contracts could provide some clues about the future price direction for the industrial commodity. November random length lumber futures settled at the $494 per 1,000 board feet level on Friday, October 14. 

Meanwhile, the November physical lumber contract was nearly $100 per 1,000 board feet higher at the $590 level on October 14. Since the new contract reflects a smaller quantity and truckloads instead of railcars, it could better reflect actual lumber prices. 

The reason a recession could be bullish for lumber prices

The latest CPI data shows that inflation continues to be a significant problem for the US economy and the Federal Reserve. The Fed has committed to fighting inflation with monetary policy tightening, despite the ramifications that weigh on economic growth. US GDP declined in Q1 and Q2 2022, the textbook definition of a recession. Q3 GDP will come out on October 27, and the odds favor a third consecutive quarterly decline, validating a recessionary environment. Recession and inflation result in stagflation, a challenge for the central bank as it requires contradictory monetary policy tools. Rising interest rates dampen inflation, but they also increase recessionary pressures. The monetary policy tool to treat a recession is a dovish approach or lowering interest rates.

In hindsight, the central bank waited far too long to address inflation. Throughout much of 2021, the Fed and Biden administration caused rising inflation, a “transitory” pandemic-inspired event. They were wrong and reversed course in March 2022 with liftoff from a zero percent Fed Funds Rate and plans to reduce its swollen balance sheet. The bottom line is the pandemic response, central bank liquidity, and government stimulus planted the inflationary seeds that caused inflation that was anything but “transitory.”

Meanwhile, the Fed and administration are now calling the rising recessionary data a “transition.” The central bank was wrong about inflation last year and is paying for the mistake in 2022. The Fed could make the same mistake in 2022 as it ignores the recessionary data. An epiphany in 2023 could cause the Fed to curb its enthusiasm for rate hikes and reverse course to a dovish monetary policy approach. Falling interest rates could cause another boom in demand for new homes and lift lumber prices currently sitting below the $500 per 1,000 board feet on the random length contract and under $600 on the physical contract.  

Lumber remains a critical barometer for the housing market and economy

Lumber is a critical barometer that often moves higher or lower before other commodity markets. The low liquidity compared to other raw material markets tends to cause wood to explode or implode when other commodity futures markets are just beginning to move. Bids to buy disappear when the price action shifts to bearish trends and offers to sell evaporate when bullish trends emerge. Keep an eye on the random length and physical lumber contracts over the coming weeks and months, as they could provide valuable clues about the path of least resistance of the overall commodities asset class and the US economy. 

I believe the Fed is overdoing it with the aggressive hawkish monetary policy path. In 2023, we could see a sudden reversal as recession replaces inflation as the central bank’s number one enemy. 

More Softs News from Barchart

On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes.

Provided Content: Content provided by Barchart. The Globe and Mail was not involved, and material was not reviewed prior to publication.