In my last blog post, I explored how the dramatic growth of “long-only index” funds has affected the Chicago futures market. These funds focus on worldwide inflation forecasts in making their investing decisions and have maintained their long positions irrespective of what is happening in the wheat market. Accommodating this huge new semi-permanent demand for long positions requires attracting many more short sellers. “Long-only index” funds must make the short positions of hedgers—farmers and grain handlers—more attractive and profitable, so they will hedge and store wheat that normally would be sold on the cash market. The higher the futures price is above the expected cash price (i.e. the more negative the basis), the more attractive hedging becomes. This difference is the “fee” paid by the “long-only index” funds to maintain positions unrelated to the basic supply and demand for wheat.
After some worry, I’ve come to the conclusion that farmers can safely take advantage of this market distortion. When futures prices are above expected cash prices, hedgers will normally make money and the “long-only index” funds will lose money. Farmers will lose only if they must close out their hedge positions during a period when the funds are building their long positions and causing the basis to widen.