Elise Schafer, editor of Feed & Grain: Hi, everyone, and welcome to Feed & Grain Chat. I'm your host Elise Schafer, editor of Feed & Grain. This edition of Feed & Grain Chat is brought to you by WATT Global Media and Feedandgrain.com. Feedandgrain.com is your source for the latest news, product and equipment information for the grain handling and feed manufacturing industries.
Today I'm joined on zoom by Owen Wagner, senior analyst grains and oil seed with RaboResearch. He's here to talk about the U.S. economy and its implications on grain and oilseed demand. Hi Owen, how are you this morning?
Owen Wagner, senior analyst, grains and oil seed with RaboResearch: I'm doing well, Elise, good to see you. Hope all is well on your side.
Schafer: Good to see you, and thanks for joining me. Now could you talk about the importance of indicators like the yield curve for bonds and Federal Reserve Bank's interest rate. And given these indicators, what's your take on a recession in the coming months?
Wagner: Sure. And I appreciate the question, Elise, it's really a great way to lay the foundation for any discussion of the connectivity between the macro economy and the commodity markets that your audience pays so much attention to. And the yield curve. It's a bit of an esoteric term, right. But it's one I feel like we've all become more and more familiar with, over the last year in this in this age of connectivity. It's one that we've certainly heard referenced in many of the evening news or any kind of financial publications.
It can be a little bit of a difficult concept to wrap your head around for the for the uninitiated, but effectively what people are talking about when they when they refer to the yield curve is the return or the yield that you would get on government debt, issued by various ages of maturity, whether that's one month, three months, 10 years, 20 years, 30 years, etc. In theory, you should be awarded for with a higher yield on that investment for locking your money over a longer period of time. So, under normal economic circumstances, the yields on a 30-year treasury will be higher than on a, one month or three month treasury.
The situation that we've been in since about last June, however, has been what's referred to as an inverted yield curve where you get yields on shorter term treasuries, ultimately higher than those of longer term which sort of flips the logic on its head. And there's been a lot of research for why this is the case. And it can come from sort of two angles, there's sort of a, a bottom up line of thinking or a top down. I'll just take a second to explain those, two different scenarios under the top-down approach, which I think is the one that we're probably in right now, you get a situation in which the Federal Reserve is going to raise interest rates near nearby interest rates very quickly, you know, at relatively high levels. And that causes a sharp increase in those interest rates in the near term.
Then the expectation of the market is that longer term, the Fed will have to cut those rates in order to help dig us out of some sort of economic turmoil. So that's the top-down argument. The bottom-up argument is if you have market participants believing that perhaps they're worried about growth in the short term, they're a little bit spooked by the stock market, they want to see security longer term. They'll bid up bond prices for these longer term maturity profiles, so 20 to 30 years out, and there's an inverse relationship between these bond prices and yields. That will ultimately cause the yields on those longer-term treasuries to fall to lower levels and those of the short term.
Again, under normal circumstances, you'd expect the rates that you can get from longer term borrowing to be higher to reflect the risk that one incurs by locking up that money longer term. But when the markets get a bit spooked the threat of recession, it flips that relationship on its head. The reason that economists increasingly, anyone that that participates in the broader economy pays attention to this is that an inverted yield curve has accurately predicted all of the last 10 recessions and it's only had one false positive in the last 70 years, and that was that was dating all the way back to the mid-60s. So, it's not a predictor, but it's a very, very accurate indicator of recessions historically.
Schafer: Now, historically, what does the research show on the implications of a recession on the supply and demand of U.S. grains and oilseeds?
Wagner: This is where things get really interesting because people have to eat right, regardless of what the economy is telling them, we all have ourselves to feed at a minimum, and many of us have a family and dependents to feed and so that's something that's not going to change regardless of your economic circumstances. Sure, you can make some decisions here and there at the margins of do I buy steak tonight or do I buy chicken based on how I feel about my job prospects?
This all gets back to a notion of your income elasticity of demand. So, if I'm doing well, if I feel secure in my financial future, I'm going to buy those items that are vital to me. But in all cases, food is vital. And like I said, we have a little bit of discretion, as consumers as it pertains to food at the margin, we can get those more luxury goods, if we feel that the times will be good, and maybe scale back when things get a little bit tighter. But there are quite a few commodities, Elise, that are much more discretionary in nature than food.
Starting with some of the more obvious ones, cotton is a great example. Obviously, when times are good people may go to the mall, they might buy that new suit, that new dress, and you see cotton demand rise accordingly. It's no coincidence that if you go back to last summer, June or so of last summer, when the Fed embarked on this cycle of interest rate increases to help tame inflation, that cotton prices were the first to fall out of the gate. I mean, they fell dramatically, I think it was 40% to 50% in the three or four months span, because cotton in many ways is that canary in the economic coal mine. It's durable, it's discretionary, it can be kept in a warehouse and stored and people can just forego those clothing purchases until times are a bit better.
Interestingly, oil, and many of us may not think of it as such, but petroleum is also very discretionary in nature. When times are tight, we may not take that vacation, or we may not order that new lawnmower that new durable good that requires a lot of energy to manufacture. And so all of those collective decisions, they have a cumulative effect curtailing that petroleum demand at the threat of recession, and that that transfers through to lower petroleum prices. Now, the reason I'm mentioning oil is that — this is supposed to be a conversation about agriculture, right? In the past oil and agricultural commodity markets moved very independently from one another. In the webinar that you participated in a couple of weeks ago, we showed some diagrams, showing that prior to the 2000s, there was essentially no relationship between corn and in petroleum prices.
Fast forward to 2006 to 2007, a fairly convincing relationship began to emerge. And really the root of all this goes back to biofuels and the renewable fuel standard in this country in particular. And as you've seen that mandate grow over time, you've now got something like 40 to 45% of corn production in this country is used for biofuels. 45% of soybean oil is used for renewable diesel or biodiesel. And so obviously, that creates a very strong link between these petroleum markets and these agricultural commodity markets. So now with that link firmly established, you've got this floor that’s set by petroleum, these flashing red lights of a recession beginning last June, pulled the rug out from under the economy, petroleum prices crashed, and then we saw corn, soybeans, and then ultimately even wheat, which has relatively little connectivity with biofuels all fall in suit. And that's really been the cycle that we've been in for the last 14 or 15 months.
Schafer: How do you think a recession would impact the demand for renewable diesel or aviation fuel and for how long is the kind of growth that we've seen in this sector sustainable?
Wagner: This is where, understanding of the policy can help with the renewable volume obligations that are set by the EPA, and those are associated with the Renewable Fuels Standard, again, the big federal program are set in stone. So those volumes do have to be met, which can help make things a little bit more fixed. But that said, there are many biofuel programs operating independently all over the world. If you look at Southeast Asia, for example, that's home to some of the cheapest vegetable oil in the world. In fact, if you go to the interior of some of these islands in Indonesia, where palm oil is produced, palm oil is significantly cheaper than petroleum. That creates an opening for discretionary demand that can ultimately you know, weigh on the entire veg oil complex in agricultural commodities at large. Again, when those petroleum prices fall. Now in the United States, we obviously have the federal program, which volumes are fixed, which helps provide a bit of a guarantee.
But then in California, we have the low carbon fuel standard and the LCFs of California has been incredibly important for the recent growth of renewable diesel. But an interesting thing happened during COVID. What we saw during COVID was that many of the traditional petroleum companies in the United States began to pull back on refining because they were anticipating lower demand. Whereas those producers of renewable diesel or ethanol that were supplying to the California market, they continued to produce in force.
The way that the California program is designed is that you don't have the set mandates. Instead, it's these production targets are set in accordance with a carbon intensity score, which I don't think we need to go into today. But effectively, what ended up happening was, you had a glut of these renewables on the marketplace, more than the market could absorb because during COVID — everybody was holding back on driving, they were working from home. That led to a crash in some of these LCFs credit values. And that ultimately does ripple through to the prices that will be paid for the commodities that are used to produce those renewable fuels.
Schafer: Well, Owen, thank you so much for your insights today.
Wagner: Thank you, Elise. I really appreciate the opportunity to share and hope everyone has a great rest of the harvest season.
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