Business Insider

Peter Crabb: Markets don't share Obama's rosy view of the economy's future

On cold winter days like these, my mother frequently reminded me to wear my coat. But like many young boys I often didn’t listen. These days I am a better listener when my mother shares her wisdom. Policymakers in Washington and elsewhere should also learn to be better listeners.

The financial markets offer a wealth of information for business managers, consumers, and policymakers alike. The most forward-looking of the markets is that for financial derivatives, such as futures and options.

These financial markets are often thought of more as casinos than a source of information. But the derivative markets involve real decisions by investors and business managers using the capital they have under management. As such they are the most unbiased forecasts of future economic and business conditions. You can survey economists and others all you like, but only in these markets are people putting real money to work.

This week President Obama sent the 2011 budget proposal to Congress. The proposal includes expectations for economic growth and inflation over the next decade. The estimate for growth in real GDP during 2011 is 4.3 percent compared with a decline of 2.4 percent in 2009. Inflation during the 2011 calendar year is expected to be only 1.2 percent compared with a nearly 3 percent in 2009.

The outlook in the futures markets is much different.

A futures contract is a standardized agreement to deliver or take delivery of an asset, such as corn or gold, at some time in the future. Since the contract is standardized, only the price is determined by traders in futures contracts. The actual contract specifies all other particulars, such as the quantity of the asset delivered and the ending date of the contract.

Trading of standardized contracts, such as those on the Chicago Board of Trade and Chicago Mercantile Exchange, provides liquidity and guaranteed settlement. The exchange provides a guarantee to traders that the other party to the contract will meet its obligations. With these guarantees market participants can be more confident they are receiving a just price. The current price of a futures contract is closely related to the price of the underlying asset being sold each day by producers and users. However, the price of a futures contract tells us more. If supply and demand conditions for the commodity change, the current, or spot, price changes, but the futures price is also affected.

When the price for exchanging the good today rises, the futures price is also likely to rise. But it is possible that some traders expect the rise in the spot price to be temporary and that the futures value will be lower. Thus, futures prices reflect market participants’ expectation of spot prices in the future. Lower futures prices reflect an expected decline in spot prices; higher futures prices reflect an expected increase.

For example, recent activity the oil market suggests a dramatic rise in the price of oil during 2011. The spot price of light crude pil as traded on the New York Mercantile Exchange is around $77 per barrel. But if you don’t want to take delivery of the oil you need until December 2011, you will have to pay more than $84 per barrel for the futures contract. This represents an expected increase of more than 9 percent.

Many other prices are forecasted to rise. The corn futures contract for December 2011 is more than 15 percent higher. Prices for natural gas are expected to rise 25 percent over the same period.

As for economic growth forecasts, we must look to the stock market futures. One- and two-year futures contracts on the value of stock-market indexes like the Dow 30 and the S&P 500 are currently priced lower than the spot value. There is no expectation for economic growth here.

Knowing the expected level of prices for commodities, interest rates, or stock values helps business managers plan better. Policymakers can do the same. The futures market is forecasting higher inflation and slower growth than that used to plan next year’s federal budget.

Listen to the markets.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.