What Is an Inverted Market?
In the context of futures markets, an inverted market occurs when the spot price and near-maturity contracts are higher in price than far-maturity contracts. The situation may arise for multiple reasons, including a short-term supply decrease, which causes prices to be higher in the short term. Or, short-term demand could be high, leading to higher prices, but demand is expected to fall in later months, leading to lower prices in the future.
- An inverted market is one where the spot price and near-term maturity futures contracts are priced higher than more-distant maturity contracts.
- A normal market is the opposite, where futures prices are increasing as the time to maturity increases. The increasing price reflects the expected spot price plus the costs associated with interest, storage, and insurance for holding the asset until maturity.
- The terms inverted and normal market refer to how futures prices compare to each other at varying maturities.
- The terms contango and backwardation refer to how a futures contract moves (rising or falling) toward the spot price as the contract moves toward expiration.
Understanding the Inverted Market
An inverted market is seen by looking at static futures prices with different maturities. If the spot price is higher than a contract that expires in one month, which is higher than a contract that expires in four months, the futures curve is inverted.
Compare this to a normal futures curve or market, where the spot price is below the price of a contract expiring in one month, which is below a contract expiring in four months. Futures prices are higher the further into the future you look.
An inverted or normal market can also occur at some maturities but not others. For example, futures may be inverted when looking out a few maturities (prices progressively lower), but looking out further than that, the prices are rising, reflecting a normal market.
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 and Backwardation
Sometimes the term "backwardation" is used in place of "inverted market." However, this isn't accurate as they are referring to different things. An inverted market or normal market refers to how futures prices compare to each other at different maturities. An inverted market sees futures prices that are lower over time, while a normal market sees futures prices that are higher over time.
Backwardation and contango refer to how a futures contract moves toward the spot price as it moves closer to expiration.
If the futures price is dropping to meet the spot price, the market is in contango. If the futures price is rising to meet the spot price, this is normal backwardation.
An inverted market can occur in either a backwardation or contango market.
Inversion and backwardation are more commonly seen together, which is why sometimes, erroneously, the two terms are used interchangeably.
Examples of an Inverted Market in Commodities
Inverted markets aren't "normal," although they are rather common. It is not uncommon to see near-term futures prices higher than more-distant maturity months. The market may also only be inverted for a few maturities, and the longer out you look, the futures prices become normal again (more-distant maturities priced higher), or vice versa.
The snapshot below shows two or three different maturities for gold, silver, copper, platinum, and palladium futures.
The black arrows market normal conditions since the price is increasing for more-distant maturities. For example, the December 2019 gold contract is priced higher than the October contract, which is priced higher than the August contract.
The red arrows point out when a particular market is inverted. The July 2019 contract for copper is priced at 2.7045, while the September contract costs less, 2.7035. This is an inversion. Notice, though, that the December contract is 2.7060, which is a higher cost again. Therefore, the market is inverted in the near term, but normal over the longer term.
Palladium is also inverted since the December 2019 contract is priced lower than the nearer September contract.