In an August 6 Barchart article on the lumber market, I concluded:
Lumber may not be able to sustain a significant rally over the coming weeks and months. Still, any price weakness could be a buying opportunity for lumber-related assets for 2025 when seasonal strength reemerges.
On August 5, nearby September physical lumber futures were at the $508 level on August 5, with the now active November contract settling at $527.50 per 1,000 board feet on that day. At nearly the $530 level in late September, lumber has remained in a tight trading range.
Lumber futures go nowhere fast
After the wild price swings that took the random-length lumber futures prices to highs of over $1,700 in 2021, and above $1,475 per 1,000 square feet in 2022, and below the $355 level in January 2023, the new physical lumber futures have traded in a narrow range over the past months.
The chart of the physical lumber futures for November delivery shows a tight trading range from $473 to $548 since mid-July 2024. At the $529.50 level in late September, lumber futures above the middle of the trading range.
Lumber is a very volatile and illiquid futures market
Lumber futures have long suffered from liquidity issues. Daily volume and open interest, the total number of open long and short positions in the CME lumber futures, are very low. The lack of hedging, trading, and speculative activity has caused significant price variance when bullish or bearish trends develop. The average daily volume in the physical lumber arena is typically under two thousand contracts, and open interest at the 8,118 contract level is extremely low.
In illiquid markets, bids to purchase the commodity tend to disappear when prices decline. Conversely, offers to sell often evaporate when prices move higher. Lumber’s illiquid nature fosters the extreme price variance that took prices to highs in 2021 and 2022 and lows in early 2023.
The CME’s new contract has not improved liquidity
The Chicago Mercantile Exchange (CME) de-listed the random-length lumber contract, replacing it with the physical contract to attract more volume and open interest. The old contract size was 110,000 board feet, while the new contract size was smaller at 27,500 board feet. Moreover, the physical lumber futures have far more flexible delivery specifications and acceptable wood grades than the random-length contract.
The quest to improve liquidity has mostly failed as lumber’s volume, and open interest has declined even though the contract is one-quarter the size and more flexible.
While lumber futures have gone to sleep over the past months, the low liquidity points to significant price volatility that will exacerbate moves when lumber futures decide to break out from the current narrow trading range.
Lumber’s price depends on interest rates
Lumber has one of the most significant correlations with interest rates as it is a critical ingredient in new home construction. When mortgage rates decline, the demand for new homes tends to rise.
In 2021 and 2022, when lumber rose to extreme highs, 30-year conventional fixed-rate mortgages were at below the 3% level, creating a new home-building boom and increasing lumber demand.
In March 2023, the U.S. Federal Reserve began increasing the short-term Fed Funds Rate and rolled out a quantitative tightening program to reduce the central bank’s swollen balance sheet and put upward pressure on rates further along the yield curve to combat the highest inflationary pressures in decades. The Fed’s actions tightened credit, pushing the 30-year conventional fixed-rate mortgage rates far above the 7% level at the highs.
The Federal Reserve’s mandate is full employment and stable prices. Recent inflation data indicate the economic condition has moved toward the central bank’s 2% target, and employment data has shown increasing job losses. The data set the stage for short-term interest rate cuts over the coming months, with the first reduction of 50 basis points at the September FOMC meeting. The Fed had already reduced its quantitative tightening activities, and told markets to expect another 50 basis point cut by the end of 2024 and 100 points of short-term rate reductions in 2025. The bottom line is that lower mortgage rates are on the horizon, which could support gains in lumber and lumber futures prices.
Expect higher prices in 2025 for three compelling reasons
The following three factors could ignite a substantial rally in lumber in 2025:
- A more accommodative central bank will cause interest rates to fall, weighing on mortgage rates over the coming months. Lower mortgage rates tend to lead to rising demand for new homes and construction.
- The historically low mortgage rates in 2020 and 2021 caused a boom in new home demand and purchases of existing homes. With many homeowners locked into fixed-rate mortgages at 3% and below, there is a shortage of homes as owners are not willing to part with their historically low mortgage rates. The low inventory levels mean new home construction will need to fill the void for new home buyers when rates decline. However, interest rates are not likely to decline to levels seen in 2020 through 2022.
- There is significant pent-up demand from first-time buyers and others looking to own new or existing homes. Home prices have soared over the past years, indicating that the demand remains robust in the current market.
I expect lumber prices to start moving higher when interest and mortgage rates decline. We could see a surge in new home demand and lumber prices over the coming months. While the winter tends to be a weak period for construction, the odds of a construction boom in the spring of 2025 are rising if the Fed begins aggressively lowering interest rates.
Therefore, the downside risk for lumber prices could be limited around the $500 per 1,000 board feet level, and the upside could be explosive. Lumber futures are dangerous because of their low liquidity, and no ETF or ETN products track physical lumber futures. However, the odds favor higher prices in 2025.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
