What is an inverted market?
In futures markets, an inverted market exists when the spot price and short-dated contracts are priced higher than long-dated contracts. The spot price is the current price at which an asset can be bought or sold. Maturity is the date when the term of the transaction or financial instrument ends and after which it must be renewed or abandoned.
The central theses
- An inverted market occurs when futures contracts with near-term maturities are priced higher than contracts with future maturities.
- In a normal market, futures prices increase as maturity increases.
- Backwardation and contango refer to how a futures contract moves towards the spot price as it nears expiry.
Understand inverted markets
An inverted market can arise for a variety of reasons, including a short-term drop in supply that causes current prices to rise. If demand is expected to fall in the future, prices will fall.
Both an inverted and normal market compare futures prices at different maturities. In an inverted market, futures prices fall over time, while in a normal market, futures prices rise over time.
A futures market is inverted when the spot price for a contract that has one month to expire is higher than a contract that has four months to expiry. In a normal futures market, futures prices are higher further into the future. The spot price is below the price of a contract that expires in one month and therefore below the price of a contract that expires in four months.
Futures are derivative financial contracts that oblige the parties to buy or sell an asset at a predetermined future date and price.
Contango and backwardation
Backwardation and contango refer to how a futures contract moves towards the spot price as it nears expiry.
When the futures price falls to the spot price, the market is in contango. Normal backwardation is when the futures price rises to reach the spot price. A futures curve is inverted when the spot price is higher now than it will be in the future. Inversion and backwardation are often seen together.
Commodities in inverted markets
The most common reason for market reversals is short-term disruptions in the supply of the underlying commodity. For crude oil futures, OPEC policy export restrictions or a hurricane damaging a Gulf Coast oil port will affect prices. Oil shipments are more valuable now than future shipments.
In the case of agricultural commodities, there may be bottlenecks due to the weather. Financial futures contracts may be subject to short-term price pressures due to changes in trade policies, taxes or interest rates.
bear cost
Normal or non-inverted markets show near-month supply contracts priced below supply contracts for later months. This is due to the costs involved in accepting the underlying goods now and storing or transporting them until a later date.
Shipping costs include interest, insurance and storage. This also includes opportunity costs, since money tied up in the goods cannot generate interest capital gains elsewhere. When the cost of a futures contract equals the spot price plus the full carry cost, it is said to be in a full carry market.
Example of a reverse market
Since 2020, some commodity futures have been consistently inverted. In March 2023, 74% of the index weight of the S&P GSCI components were trading at higher prices for one-month delivery than for one-year delivery. Brent crude futures have been in “super backwardation” since 2022. Corn, soybeans, sugar, and Kansas wheat experience the same phenomena.
Brent Crude Oil Futures Prices to March 2024. Marketwatch.com.
What is the difference between a spot price and a futures price?
The spot price is the current price in the market at which a security, commodity or currency can be bought or sold for immediate delivery, specific to a time and place. Unlike the spot price, a futures price is an agreed price for the future delivery of the asset.
What does backwardation mean for investors?
For investors, lower futures prices or backwardation signal that the current price is too high. Therefore, they anticipate that the spot price will decrease as the futures contract expiry dates approach.
What types of futures contracts are there?
Types of futures contracts include commodity futures such as crude oil, natural gas, corn and wheat, currency futures such as the euro, precious metals futures for gold or silver, and US Treasury futures for bonds and other securities.
The conclusion
An inverted market occurs when futures contracts with short-term maturities are priced higher than those in the future. Disruptions in the supply of the underlying commodity usually lead to a market reversal. Contango and backwardation describe how the price of a futures contract moves toward expiry, either rising or falling, in the direction of the spot price.
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