Expect the unexpected in markets

When the unexpected hits, price variation can exceed the expected very quickly

Last article, I talked about managing risk and uncertainty in the markets. As you might recall, there is an important difference between the two.

Risk estimates everything we think might happen. Risk is our guess about what the future holds. More precisely, it is the range of things that might happen and how probable each event is.

Uncertainty is all the things we never imagined that could happen. That’s the key difference between risk (what can be estimated) and uncertainty (the things we never anticipate).

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Under uncertainty, the range of potential price action becomes much larger than expected. These big moves up or down can happen over days, weeks, months, years or even decades. We’ve certainly seen some of those lately.

A few examples of extreme price moves quickly come to mind and we’ll see that there is a common thread that runs between them. Consider that for over 30 years, gold had been pegged at $35 to the U.S. dollar. Then when the inflationary 1970s took over, gold marched steadily higher for 10 years to over US$600/ounce by 1980. Gold was viewed as the ultimate inflation hedge until that trend came to an end as it dropped to under US$300/ounce by 2000.

Up next, then, we have the case of interest rates. Interest rates over the past 40 years are a great example of the persistence of a long-term trend. Back in the 1980s, the U.S. Federal Reserve pushed short-term central bank Fed Funds rate to 20 per cent (which helped to pop the aforementioned gold and inflation bubble). At the same time, 10-year U.S. Treasury bond yields were at 15 per cent. Since then, they have come all the way down to 0.5 per cent, albeit with some intermittent jumps higher along the way.

Low rates seem to be here to stay especially in this current environment. In fact, long-term history has shown that low rates (well, maybe not this low) are actually the norm, rather than the exception.

Or, how about this? From 1995 up until the technology bubble top in 2000, the NASDAQ stock index moved up at quadruple the annualized rate of the previous decade. This trend that built up over the course of those five years subsequently reversed as the NASDAQ index proceeded to drop 80 per cent over the next two years. At its peak, many investors wanted to believe that these tech and dot-com stocks would just continue to move higher. They were surprised at just how far they fell afterwards.

More recently, there’s bitcoin, which was only a couple of bucks in 2011. Eventually, it moved up to US$20,000 by the end of 2017 before collapsing to around US$3,000 a year later. It then jumped back up to US$14,000 by mid-June 2019 and now sits around US$10,000. Those are some big and incredible price moves.

A shorter-term example is the Swiss franc. For three years between 2012 and 2015, the Swiss franc was pegged to the euro at a rate of around 0.80. The Swiss central bank sold the franc and bought the euro to hold down the franc, effectively tying the two currencies together. Then one day in early 2015 during the European debt crisis, the Swiss central bank stopped buying the euro and discontinued the currency peg. In a matter of hours, the Swiss franc increased almost 50 per cent versus the euro.

Another dramatic price move occurred in hard red spring wheat in 2017. From the beginning of June, as hot dry weather developed across the growing regions, Minneapolis futures started to climb… quickly. Prices increased steadily almost daily, from about US$5.50/bushel all the way up to around US$8.50/bushel by the beginning of July. By fall, prices were back down to US$6/bushel.

Lastly, while the recent oil plunge to negative $40 was a one-day event (shocking in itself), oil prices have also shown persistent price activity over long periods of time. Since it hit $140/barrel during the euphoric year that was 2008, it really has been trending lower since then. It hovered near US$100/barrel for four years between 2011 and 2015. Then it dropped and traded in a range averaging more or less around US$50/barrel for five years between 2015 and 2019. It is now at US$25/barrel. Based on historical price patterns, oil could stay within a wide range around US$25/barrel for a few years to come.

So, there’s no shortage of examples of extreme price movements. The common thread is that these moves can go further than you thought possible and last longer than you could imagine. While being aware of them, understanding them and learning from them is good, more important is how it relates to farm marketing decisions. One approach to dealing with volatile market conditions is to hedge incrementally over the course of the crop year. This help diversifies the timing of your pricing decisions to better manage the associated risk. Also, flexible option strategies are naturally a great tool for price volatility and uncertainty. They give you the downside protection you need with the upside potential you want. Finally, if you see a really strong basis level or an extremely good cash bid, take it for some of your grain. Combined, these can all be part of a portfolio of sound marketing decisions.

Bottom line, most of the time, perhaps up to half of the time, markets move in what can be considered a sideways trend. Although, whether a short-term event, medium-term trend or long-term condition, markets can and will surprise you more than you thought possible. When they do, have a proactive game plan with a range of hedging strategies in place to capture more of the large moves higher, mitigate some of the big drops and manage revenues over time.

About the author

Columnist

David Derwin is a commodity portfolio manager with PI Financial Corp. The views here are his own, presented for educational purposes, rather than as specific market advice. For a copy of the complete research study “Farming Big Data — Myths, Misperceptions & Opportunities in Agriculture Commodity Hedging” contact him at [email protected]

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