Ag Options: Caught in the Fed's Monetary Policy Vortex

Options on corn, soybeans and wheat futures have been in an exceptionally low volatility environment for the past several years. And, implied volatility on crop options continues to trade near the lowest levels since 2007 when Quikstrike’s time series begin (Figures 1, 2 and 3). 

Figure 1: Corn Options Have Rarely Been Less Expensive.

Agriculture options aren’t alone.  Options on many other seemingly unrelated assets also continue to trade near record low implied volatility, including currencies, bonds, precious metals and equities, despite the recent bout of volatility.  What’s more is that all these options markets follow a cycle that appears to be related to U.S. monetary policy.  When monetary policy is easy, market liquidity becomes abundant and the cost of options falls along with unemployment and credit spreads.  As the cost of options falls and employment markets tighten, the central bank begins to tighten policy.  Eventually, policy tightening provokes a downturn in employment, widening credit spreads and a sharp rise in market volatility.  Higher unemployment and more volatile markets cause the Federal Reserve to ease policy, steepening the yield curve.  The cycle then begins anew.

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Figure 2: Since 2007-09, Soybean Options Implied Volatility Has Fallen by Half.

Figure 3: 10 Years Ago, Wheat Options Implied Volatility Averaged 37%. Recently it Traded Near 20%.

Before delving deeper into the behaviour of agricultural options, let’s review equity index options as a point of comparison. What’s remarkable today is how low implied volatility in equities still is: even after a sharp selloff in October, the VIX index of options on the S&P 500, barely cleared 25% (Figure 4). Equity index options have the longest implied volatility history and have been through three successive monetary policy cycles, 1990-2000, 2000-2008 and 2008 onward (Figures 5-7).

Figure 4: Even After Recent Corrections, Equity Index Options Still Trading Cheaper Than Usual.

Figure 5: The First Monetary Policy-Equity Implied Volatility Cycle Occurred in the 1990s.

Figure 6: The Second Cycle Occurred Between 2000 and 2008.

Figure 7: The Current Cycle is Moving More Slowly and Hasn’t Been as Smooth.

What’s curious is that since 2007, despite having a near zero correlation with equities, the agricultural goods options market has followed largely the same pattern.  Volatility rose from 2007 to 2009, peaked in late 2009 and early 2010 and has fallen steadily since (Figures 8-10).

Figure 8: Will Corn Volatility Turn Up as Yield Curve Becomes Flatter?

Figure 9: Soybean Options Volatility has Fallen by Half Since Late 2009.

Figure 10: Wheat Options Volatility Soared During the Crisis and has Come Down Since.

One could argue that the cycle in agriculture options volatility has nothing to do with monetary policy and everything to do with weather.  For instance, 2007 featured a La Niña, which morphed to an El Niño in 2009 and then back to a La Niña in 2010.  It could be that these changes in equatorial sea surface temperatures in the Pacific impacted crop yields, prices and implied volatility on options.  That said, our research indicates that while La Niñas are historically associated with above-normal volatility, El Niños typically feature rather average levels of volatility.

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 Moreover, the world experienced the most powerful El Niño on record in late 2015 which had swung to a mild La Niña by 2017.  Neither one produced much of an uptick in volatility during a period of easy monetary policy.

As such, it seems reasonable to suppose that implied volatility in corn, soybeans and wheat may be more strongly impacted by financial conditions than is commonly understood.  The 2008 financial crisis produced enormous moves in the currencies of major agricultural exporters, including Brazil, Canada and Russia, as the U.S. dollar soared in late 2008 and then fell back in 2009 and 2010. These currency movements, in turn, changed the relative costs of production for corn, soy and wheat, increasing their price volatility.  Even that, however, can’t really explain the degree to which implied volatility rose in the period from 2007 to 2009. Emerging market currencies have crashed recently with no noticeable impact on the cost of crop options.

Rather, in 2008 and 2009 as markets seized up during the subprime crisis, there simply weren’t many people willing to take the other side of options trades.  Brokers and banks reigned in risk- taking, leaving market makers reluctant to buy or sell insurance, or options, on crops.

Currently, the agriculture options market is in the same boat as several seemingly unrelated markets to which agricultural goods prices normally show close to zero correlation.  After many years of easy monetary policy, ag options are trading near record lows, just as options on Treasuries, equity index futures, currencies and precious metals. Meanwhile, the Fed is taking away liquidity.  So far, it has raised interest rates eight times and promises to go a ninth time in December, and perhaps even further in 2019 and 2020.

Already the Fed’s tightening has flattened the yield curve from a 300-basis-point (bps) difference between 30Y Treasury yields and 3M T-Bill rates to around 100 bps.  In previous cycles, it took  about one to two years before analogous policy tightening produced a sharp, sustained rise in volatility.  The markets higher volatility regime is roughly twice as volatile as its lower volatility regime.  As such, if the Fed’s current tightening cycle results in a similar size increase in volatility, look for corn, soy, wheat and perhaps other agricultural markets to become much more volatile as we head into the early 2020s.

It is always possible that the Fed could back off its rate increases if faced with a continued decline in commodity prices, a sharp correction in the stock market or an abrupt widening of credit spreads. If the Fed was to do so, that might keep markets in a low volatility regime for longer.  That said, with unemployment at 3.7% and wages rising at above 3% per year, the Fed appears, for the moment, to be going full steam ahead towards tighter policy despite a lack of obvious inflationary pressure.  

Bottom Line:

  • Since at least 2007, when the Quikstrike data series begin, agricultural options markets have followed those of gold, US Treasuries, equity index and currency options in a cycle with U.S. monetary policy.Tighter U.S. monetary policy risks shifting all of these options markets, including those for corn, soy and wheat, into a much higher volatility state.
  • When monetary policy is easy, market liquidity is abundant.  Buyers and sellers find one another easily and realized volatility is low.  As such, market participants can buy and sell insurance (options) inexpensively.
  • Following a period of tight monetary policy, market depth can decline and volatility (both realized and implied) can increase.
  • The cycle in corn, soy and wheat option implied volatility is more easily explained in terms of financial conditions than it is term of weather phenomena.

 

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(s) 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.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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Our research shows that implied volatility in markets for corn, soybeans and wheat seems to correlate to the Fed's monetary policy stance. With the Fed raising rates eight times in this cycle, with another likely in December and more coming in 2019, is volatility for agricultural markets set to jump? Hedge your portfolio with options.

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