The Market Corner: The Month in Review "It’s cold outside!"

By Filippo Lecchini

It’s cold outside!

The last few weeks and the start of the New Year quickly reminded everyone that volatility in the markets not only comes as a consequence of human decisions, whether is the Government’s policies, trading activity or innovation, but also follows long term cycles not always as predictable as people wish they were.

Several States in the US are experiencing an extended spell of extremely cold temperatures. A winter cyclone on the East Coast has dropped significant amounts of snow, even in the South and areas for which this is rather unusual.

After a few milder winters we might finally be at the beginning of a new phase, expected to bring back colder weather. El Niño and La Niña are often referenced in the news and public discourse and in a nutshell it seems that a long expected transition to the latter might have finally begun. It has been a matter of debate since the end of 2016 when warning signs started to materialize, depending on which part of the world you live in, but eventually the two phases are naturally expected to alternate.
The effects of the cold temperatures were immediately felt on the commodities market. Natural gas spiked to reflect the increased demand but also the infrastructure limitations, namely pipeline capacity. Electricity prices followed a similar dynamic.

Agricultural commodities are reacting as well. Coming out of a period relatively quiet for grains everyone is being quickly reminded that historically there is a relationship between temperatures and volatility.

Volatility is ultimately demand and supply at work. Its the interaction of market forces continuously seeking an elusive balance that can be jeopardized at all times by external circumstances. The futures market behaves in the same way even though the motives can be different. When we look at the spot market for grains the farmers are the only natural sellers and everyone else is a natural buyer, but derivatives allow participation for traders, intermediaries, hedgers and all sorts of agents, broadening the economic relevance of each market. Volatility is perceived differently by different people. Farmers don’t like it, that’s why they hedge and that is a cost, but traders love it, in an amount that does not disrupt the market at least, because they get paid for providing liquidity. Then there are second order effects: during a snowstorm flights are cancelled, restaurants remain empty, and nobody goes to the movies, so nobody needs a baby sitter.

A non-economic event has wide economic repercussions. The primary function of the financial markets is transferring risk between agents, regardless of motive and while the spot markets and the derivatives markets might occasionally diverge, real world developments reinforce their natural correlation, creating opportunities for profits and risk reduction.

If the start of the year is any indication 2018 will be an interesting one. The equities market and several commodities have been rallying very hard and everyone is trying to guess if a correction could be in the cards particularly for stocks that look just unstoppable even though a case could be made that earnings growth has been supporting the rally so far.

Looking ahead:

Much like looking back at the end of the year is natural for most people, looking forward at the beginning comes easy for most of us. Every year is eventful and 2018 will not be an exception.  A few issues, among many, could impact the markets in no particular order: the unresolved US budget issue, the next steps for the Federal Reserve, the Midterm Elections, more European Elections, the future of cryptocurrencies and whether the FAANG will continue their run; the list goes on.
 

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