Annualized CPI at 8%. Crude oil at $105/barrel. 10-year bond yields at 2.7%. These price levels that continually scroll over computer screens and TV sets tell a story of a macro environment undergoing material change.
But while investors are actively repricing assets in the spot markets, they are also making bets on where these assets trade on a forward basis. Most financial markets have actively traded futures markets, which, when viewed together, describe a macro landscape that can be very different from the one today. The good news is that these markets predict that inflation is near its peak. The bad news is that a successful battle against inflation will come at the cost of a slowdown in global growth.
Viewing the economy on a forward basis via futures prices provides insight into what investors expect to happen over a specified period. Knowing what is priced into markets allows investors to understand the forward narrative and adjust positions based on whether that predicted scenario is likely to unfold. Here is a quick look at where some of the major asset classes are priced one year forward:
8.5% inflation is pretty darn scary. Such high levels, though, are not expected to last. The one-year inflation rate beginning in one year, known as the 1y1y inflation rate, is 3.5%. While still higher than the average rate over the last decade, it is significantly lower than the current annualized rate of 8.5%. The forward inflation market tells us that investors think the CPI is near a peak and will slow dramatically over the next couple of years.
Forward Energy Prices
The jump in energy prices is a function of an imbalance in supply and demand. A lack of new U.S. domestic supply and the slowdown in exports from Russia, combined with renewed demand as the world emerges from the pandemic, has led to a spike in spot oil and gas prices. However, the forward market is forecasting that the recent $100+ crude levels will not last that far into the future. May 2023 WTI crude futures trade at $89/barrel compared to May 2022 futures priced at $103. The market anticipates either a resumption in supply will correct the imbalance or a slowdown in aggregate global demand will bring prices back down.
Forward Interest Rates
Everybody who follows the bond market knows that short-term and long-term interest rates have jumped over the last several months. Bond yields have soared and the yield curve has flattened. Without a doubt, the recent sell-off has been one of the most violent in decades. Fortunately for bond investors, forward markets tell us that the worst may be over. The current shape of the yield curve anticipates that 1-month Treasury rates will rise by almost 300 bps over the next year, but 30-year rates will rise by just 5 bps. To be clear, this is not a forecast; it is what the forward markets are currently pricing. The bond market predicts that the Fed will raise interest rates aggressively over the next year, but long-term rates have already made most of their adjustment higher.
Putting it all together
Looking at the various futures curves to observe what is priced into financial assets, it is not hard to form a narrative that is quite different from the one currently dominating the headlines. While spot markets tell a story of out-of-control inflation, rising bond yields, and skyrocketing energy prices, forward markets predict a macro environment that is considerably more sanguine.
Forward markets predict inflation will moderate over the next year, primarily due to lower energy prices, allowing the Fed to avoid raising rates much above 3%. Financial markets are not anticipating a 1970s-style scenario of prolonged inflation, continually rising oil and gas prices or double-digit bond yields. That is positive. However, the common thread that would allow the forward markets to accurately predict of the future is a material degradation in global growth.
Forward pricing of crude oil, inflation swaps and bond yields are consistent with a global economy that has overcome supply chain bottlenecks and is expected to slow over the next year as higher interest rates take a toll on consumer and business demand. If you don’t believe that narrative, place your bet in forward, not in spot markets.