What is an Inverted Market
In the context of futures markets, an inverted market occurs when near maturity contracts are higher in price than far maturity contracts. Another term for this condition is backwardation.
BREAKING DOWN Inverted Market
An inverted market, or backwardation, is a situation where the futures market price of a commodity is above the expected spot price at the same maturity. Typically, in this type of market, we see the near-month contract above the middle month contract, which is above the far-month contract. The curve of price vs. maturity would be downward sloping.
In contrast, a regular, or non-inverted market, has an upward sloping price vs. maturity curve. Another name for this condition is contango.
When a market is inverted or in backwardation, it describes a situation in which the delivery price of a particular futures contract has to converge downward to meet the future expected price. If prices did not converge, it would set up an opportunity for investors to profit from arbitrage. Inverted situations can be costly to investors holding net long positions since futures prices necessarily fall, all else held constant.
For example, assume an investor goes long with a futures contract at $100. The contract is due in one year. If the expected future spot price is $70, the market is in backwardation, and the futures price will have to fall (unless the future spot price changes) to converge with the expected future spot price.
Causes for Inverted Markets
The most common reason a market inverts is due to short-term disruptions in supply of the underlying. For crude oil futures, that could be an OPEC policy to restrict exports or a hurricane damaging a crude oil port on the Gulf coast. Therefore, deliveries now are more valuable than deliveries later in time.
Agricultural commodities might see shortages due to weather. Financial futures might see short-term price squeezes due to changes in trade policy, taxes or interest rates.
Regular, or non-inverted, markets show near month delivery contracts priced below later month delivery contracts. This is due to costs associated with taking delivery of the underlying commodity now and holding it, or carrying it, until a later date. Carrying costs include interest, insurance and storage. They also include opportunity costs as money tied up in the commodity cannot earn interest capital gains elsewhere.
When the cost of a futures contract equals the spot price plus the full cost of carry, that market is said to be in full carry. Contango markets can be above or below full carry. Clearly, an extreme deviation below a full carry condition could put the market into backwardation.
There is a caveat in that some markets, most notably energy, inverted or backwardation is normal, at least for long stretches of time.