Inflationary pressures are affecting the economic performance of many of the leading industrialised nations. Commodity costs are one of the contributory factors behind the surge in inflation, European Union (EU), United Kingdom (UK), and U.S. data shows. In all three economies, inflation has risen to near double-digit levels compared to the same period 12-months earlier.

Policy makers have begun to lift interest rates from record all-time lows in attempts to curb heightened inflationary pressures. Market participants have turned to CME Group Interest Rate futures and options to manage rate risk uncertainty in the months ahead. Broader commodity input costs, which directly feed into headline inflation numbers, can also be hedged in the CME Group futures and options markets.

In the EU, Eurostat data shows that the annualised inflation rate was 9.1% in August 2022,1 with energy costs contributing 38.3% to annual rate of inflation. The higher costs from energy feed into the broader market for finished goods as higher production costs are passed onto end-consumers.

A similar picture has emerged in the U.S. Bureau of Labor Statistics (BLS),2 where inflation has been rising month-on-month in 2022. Whilst the latest data for August 2022 shows that the annual Consumer Price Index (CPI) fell for the second straight month in a row to 8.3%, it remains well above the U.S. central bank target rate of around 2%. The energy index increased by 23.8%, which was below the 32.9% increase seen in July 2022.

Commodity indices reflect price increases

The S&P GSCI is a broad measure of the price of commodities, representing a composite of 24 commodities sectors from energy to agriculture and livestock to metals. The GCSI has risen 34% since the beginning of 2022 and is up over 213% from its 2020 lows. For 2022, energy remains the largest sector weight in the GSCI.3 WTI crude oil is 20.34% and Brent crude oil is 17.18% of the index in 2022, according to S&P Dow Jones indices.

The chart below shows the index value change in both the S&P GSCI and the BCOM (Bloomberg Commodity Index). In both cases, the indices track the price of WTI crude oil closely.

The crude oil price and the price of refined products, such as diesel or gasoline, indirectly affects input costs like transportation, manufacturing, and heating. All these factors affect the finished goods cost for many everyday items. High oil prices clearly have an impact on economic growth. However, the extent to which oil price increases lead to a rise in the cost of goods also depends upon how important oil is in the production process.

The chart below shows the rate of change in CPI and prompt futures contract month for NYMEX WTI Light Sweet Crude Oil. The high oil prices seen during Q4 2021 and Q2 2022 have impacted the CPI

The industrial sector accounted for about one third of the U.S.’ total energy consumption. The main energy sources of the industrial uses of energy are natural gas and petroleum, which together account for almost three quarters of supply.

Within the industrial sector, manufacturing accounts for by far the largest share of energy consumption followed by mining, construction, and agriculture. In 2021, manufacturing represented 81% of total U.S. industrial energy consumption, making the industry highly exposed to energy price movements.

Hedging oil input costs

The following hypothetical example shows how an industrial goods manufacturer could utilize oil futures to hedge their energy costs. Crude oil is a key component to a wide variety of energy products and therefore is seen as a broad measure for energy costs. Crude oil is a deep and liquid market and can be traded up to nine or ten years forward at on any given trading day.

Each futures contract represents 1,000 barrels of oil and the size of the position will depend on any individual firm’s operation and the amount of energy that they are looking to hedge.

Hypothetical example: In Q3 2022, an industrial goods manufacturer is looking to hedge their energy cost for Q1 2023.

On August 1, 2022, the firm buys 30 lots of WTI futures for each contract month in the first quarter of 2023 for a total of 90 lots. The transaction prices are $82.45 per barrel for the January 2023 contract, $80.70 per barrel for the February 2023 contract, and $79.15 per barrel for the March 2023 contract.

In the following months prices of crude oil first falls, then rises. On October 14, the firm sells the 30 lots of January 2023 futures contract at $70.85, creating a loss of $348,000. On November 18, the firm further sells 30 lots of February 2023 futures contract at $83.80, resulting a profit of $93,000. On December 16, the firm sells 30 lots of March 2022 futures contract at $93.65, making a profit of $435,000.

The total profit from the hedge with CME Group WTI futures in this example is $180,000.

Importantly, any profit could be used to offset the firm’s energy costs for Q1 2023 and help to lower the effective “net purchase price” for energy.

  Futures Hedge Result
August 1, 2022 Buys 30 lots of CME Group WTI futures for each month in the first quarter of 2023 for a total of 90 lots. The prices are:
$82.45/barrel for January 2023 contracts;
$80.70/barrel for February 2023 contracts;
$79.15/barrel for March 2023 contracts.
October 14, 2022 Sells 30 lots of CME Group WTI futures January 2023 contracts. The transaction price is $70.85/barrel. Loss: 30 lots x 1,000 barrels x ($70.85 - $82.45) = -$348,000
November 18, 2022 Sells 10 lots of CME Group WTI futures February 2022 contracts. The transaction price is $83.80/barrel. Profit: 30 lots x 1,000 barrels x ($83.80 - $80.70) = $93,000
December 16, 2022 Sells 10 lots of CME Group WTI futures March 2022 contracts. The transaction price is $93.65/barrel. Profit: 30 lots x 1,000 barrels x ($93.65 - $79.15) = $435,000
Futures profit/loss   Total Profit: -$348,000 + $31,000 + $145,000 = $180,000

Another way to hedge against price increases is through options contracts. In general, call option contracts provide the buyer protection against rising price, as the value of the option will also increase. Conversely put option contracts provide the buyer protection against falling prices.

Interest rate volatility spurs higher SOFR volumes

Recent developments in the SOFR futures and options liquidity pool demonstrates that these have sufficient volume and open interest to be suitable hedging tools. Please refer to the chart below for the latest trends in volume and open interest.

Source: CME Group

The Federal Reserve has embarked on an aggressive tightening cycle to address the current inflation levels. Three-Month SOFR (SR3) futures are one of many tools in the CME Group STIR complex that firms exposed to potentially higher interest rates can use to manage the risks associated with further tightening. If you believe borrowing rates will continue to rise and you want to lock in today’s interest rates, you could establish a short position in SR3 futures.

Example: Hedging interest rate volatility can provide some relief

As of July 22, 2022, our 30-Day Fed Funds futures implied a significantly lower effective Fed Funds rate, 2.80% (=100.00-97.200) (Dec-23 FF), at the end of next year (2023), than at the end of this year (2022) 3.305% (=100.00-96.695) (Dec-22 FF). With an effective Fed Funds rate that is 50.5 basis points lower, the market is suggesting that the Federal Reserve will be in an easing cycle by the end of next year.

If we believe the market is overly optimistic about the Fed’s ability to rein in inflation to its stated target of 2% in the coming year, we could sell Dec-23 SR3 futures, which are trading at 2.705%=97.295 to lock in that rate.

Suppose a borrower requires $100 million for three months (91 days) starting 17 months from now (from 12/20/2023 to 3/19/2024). Selling 100 Dec-23 SR3 futures at a price of 97.295 is like borrowing at a forward rate of 2.705% (=100.00-97.295).

If we assume identical moves in Fed Funds and SR3 futures, if and when Dec-23 Fed Funds futures appear “neutral” relative to Fed monetary policy, Dec-23 SR3 futures are projected to fall by 50.5 basis points to 96.79 (-0.505=96.695-97.20).

Since the trade was initiated in July 2022, Fed Funds futures have transitioned from projecting easing/lowering rates to neutral/unchanged monetary policy at the end of 2023. The combination of aggressive tightening, with at least three 75 basis point rate hikes projected in 2022, and the transition to neutral policy have made selling the Dec-23 SR3 futures significantly more valuable than we projected. Currently, as of 19 September 2022, Fed Funds futures are implying nearly identical effective Fed Funds rates at the end of this year (2022) 4.04% (=100.00-95.96) (Dec-22 FF) and at the end of next year (2023) 4.10% (=100.00-95.90) (Dec-23 FF).

Please refer to the table below for the positions established and covered for this hedge.

Date Futures Hedge Result
July 22, 2022 Sells 100 Dec-23 Three-Month SOFR futures at a price of 97.295  
September 13, 2022 Buys 100 Dec-23 Three-Month SOFR futures at a price of 96.26 Profit: 100 contracts x $2500 x (97.295-96.26) = $258,750

Broad impacts from energy costs

Energy costs are one key contributor to inflation. The hedging of these costs has become more commonplace amongst many large and small industrial manufacturers and the use of the futures markets has become more important. The central banks have become laser focused on management of the global economy to ensure a softer landing from the effects of inflation. As the outlook for interest rates has become more uncertain, this has created a greater market opportunity for trading in the CME Group Interest Rate futures and options.

CME Group products can be used to hedge the cost of both the commodity price inputs as well as the effects of rising interest rates to provide some certainty about the likely future direction of any price changes. 


CME Group Interest Rate futures and options

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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