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Is Volatility the New Norm?

19:24PM Oct 23, 2014

Geopolitical issues, slowing world economies and the Russian ban on dairy products are creating a pattern of volatility that could linger.

Last week was marked by volatility in nearly every market. Wall Street’s volatility index, considered a measure of investor fear, climbed to its highest level since 2011. 

As equity investors rushed to cover positions or shift to less risky assets, the volume of trades at the CME Group reached an all-time high just above 39.567 million contracts on October 15, shattering the previous record of 26.95 million set May 29, 2013. Some of the butter and Class IV milk futures contracts traded limit down that day, which led to an expanded trading range the following day.

The big question this week is whether the volatility is transient in scope or whether markets, including dairy markets, are headed for an extended period of rollercoaster prices.

“Last week’s market fear was global in scope,” says Sarina Sharp, agricultural economist with the Daily Dairy Report. “The European economy is showing signs of duress, geopolitical issues are plaguing a wide swath of Eastern Europe, parts of Asia, and the Middle East, and the Ebola virus continues to dominate the headlines. Until some of these geopolitical issues settle down, markets will likely remain volatile.”

On the other end of the spectrum, though, the U.S. economy appears to be improving. “U.S. jobless claims have fallen to 14-year lows, and economists expect more robust economic growth in the next year,” says Sharp. “While U.S. exports are likely to suffer as the value of the dollar improves, domestic demand could prove even more resilient. This is good news for the dairy industry because 85 percent of U.S. dairy output is consumed at home.”

However, if the other major dairy exporters, namely the European Union and New Zealand, have trouble finding buyers for the portion of their exports being displaced by Russia’s one-year ban on dairy products from these exporters, world dairy product prices will likely continue to slip, leading to even more pressure on U.S. dairy product prices.

“Milk powder prices could be particularly vulnerable in a world with surplus milk,” says Sharp.

“And if volatility persists, dairy producers and processors who use options to protect milk revenue or input costs would see the price of that protection rise. If milk prices fall under further pressure, dairy producers will have to pay more for a given put strike than they did when futures prices were higher,” Sharp adds. “In this environment, the dairy Margin Protection Program, with its static cost structure, becomes more attractive.”

She cautions, however, that dairy producers need to be careful when they are determining how much milk to cover and at what margin level because their actual on-farm margins can differ significantly from the national average margin released by USDA.

Sharp further notes that because the MPP has a feed cost element whereas milk puts are purely driven by milk price, if both milk and feed prices fall, dairy producers could be better off to protect their revenue through futures and options, even if the MPP coverage is less expensive.

“Also in an environment with falling feed costs, the Margin Protection Program isn’t protecting margins effectively for dairy producers who grow their own feed or for producers who have locked in their feed costs through inventories and/or cash contracts,” she adds.

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