World Wide Wheat Shortage?

Russian drought news has been the dominant factor in the grain market this summer. Wheat prices began to rally in early June as commercial traders fully supported the lows around $4.50 while accumulating a net long position of over 80,000 contracts. At this time, the Russian drought news began to hit the wires. The month of July was fueled by the daily weather reports across Europe as this turned out to be the worst drought in 50 years. Wheat prices sky rocketed to $8.41 by August 6th and have since been in a trading range between $6.45 and $7.34 while waiting for further assessment of the weather’s impact on this year’s crop. Facts are now replacing hyperbole. It has been reported that Russian wheat will be off by 31% along with a carryover effect to a winter wheat crop that will also be off about the same amount late this year. Global wheat production is expected to be around 660 million metric tons for 2010. Russia was expected to produce around 60 million bushels and will end up closer to 40 million metric tons. Considering ending stock surplus is around 175 million metric tons as of the end of 2009, Russia’s 20 million ton shortfall should be easily covered.

Now that the actual numbers are starting to come out, there are three important points to be made in this example.

1)   The futures markets are completely democratic. Everyone has access to trade them and the prices represent global supply and demand. This means that farmers all over the world compete to create the best available bids and offers. This also means that local farmers have access to the best global bids and offers and therefore, are not tied to the local grain elevator operator’s basis offers $.60 – $1.50 below the futures price. This is exactly the type of market inefficiency that the exchanges were created to eliminate.

2)   There have been nine years in the last 25 when global wheat production did not exceed global wheat consumption. The surplus that was created by 16 year’s worth of excess production makes up the global ending stocks and provides the cushion necessary to make up for anomalies like Russia’s drought. In spite of sporadic annual wheat deficits, at no point over the last 25 years have global wheat ending stocks dropped below 50 days’ supply.

3)   Following the commercial traders’ actions through the commitment of traders report provided actual trading opportunities while the media fueled hysteria with headlines like, “Worst Russian Drought in 50 Years,” and “Russia Imposes Ban on Exports,” “Global Warming Killing Crops,” etc. Commercial traders went from long 80,000 contracts when they collectively felt that wheat was undervalued below $4.75 to currently short 10,000 contracts. The 90,000 contracts sold represent commercial wheat traders’ analysis of their market and the consensus of all of the fundamental factors affecting it. Their actions can also be seen through technical analysis that shows the wheat market stopping dead at the 38% Fibonacci retracement level from the January ’08 highs over $15 to the lows at $4.40.

The next actionable clue to future movement in the wheat market will be seen in technical analysis that points to a retracement to $6.05. This represents a 50% retracement from the $8.50 highs to the $4.40 low. We will combine our technical expectations with commercial trader’s actions through this consolidation between $6.45 and $7.34 to form a cohesive trading plan involving both fundamental and technical analysis that cuts through the media’s noise and allows us place trades based on proactive action rather than reactive reaction.

See the first “Interesting Formation ” to view the accompanying chart. Registration is free.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Buy Bonds – Price Appreciates What Yield Gives Up

Buy Bonds – Price Appreciates What Yield Gives Up

Japan’s official interest rate policy hasn’t been above 2% since 1993. In fact, since 1996, it hasn’t been over .5% and has bounced along at zero for much of that time. Furthermore, Japan has actively increased its balance sheet through the direct purchase of corporate debt as well as absorbing numerous bad loans. In spite of this historically loose monetary policy, Japan’s major fight for over a decade has been deflation. Our own Federal Reserve Board’s decision on August 10th to leave rates steady and purchase long term notes is a strong push towards zero interest rates here in our own country and is a clear statement that the major concern here is also, deflation.

When we view the recent actions by our own Federal Reserve Board within a global context, we see the following picture emerge – Global Deflation. The largest economies in the world, U.S., Japan, England, Germany, Spain, France, etc. are all in recession and facing debt crises. In fact, the G7 as a whole is currently carrying a debt to gross domestic product ratio upwards of 110%. This means that the seven largest free economies currently are borrowing 10% more than they produce in a given year. How long could any of us run our houses or businesses like that?

China, while not in recession, is slamming on the growth brakes in an attempt to prolong their prosperity and avoid the boom and bust cycle. The combined global action is an attempt to borrow our way out of debt. The simple version is that governments lend money to be put to work creating jobs, goods and services in anticipation that each job, good or service will generate revenue in excess of the principal plus interest loaned. However, the money being loaned is not being put into the creation of infrastructure or small businesses, both of which would have lasting payoffs.

Thanks for bearing with me through the setup of the macro economic trade that’s taking place. Commodities as a whole have risen throughout the period of loose fiscal policy with gold and silver leading the way. The more money the global governments pump into the system, the more people want to place their inevitable inflation trades. These fall into three categories, buying metals, selling interest rates and selling the U.S. Dollar. The emotion attached to these trades is the “Homerun Trade.” Talk to your buddies. I’m sure that one third of them fall into this category. Listen for phrases like, “The Dollar is worthless.” “Gold is going to $5,000 dollars an ounce and I’m going to catch it all.” Finally, “Stay away from bonds. These historically low rates can’t last forever with all the money we’re printing.”

It’s been my experience in trading that the day -to -day task of trading the markets profitably has never been about catching a generational shift in market behavior. Making money in the markets on a consistent basis requires following the major players and the moves they create. This requires the ability to set aside personal feelings of any given market and fall in line with those who are collectively smarter than we are.

The most dynamic setup is in the interest rate complex. People have been reluctant to buy bonds since late 2007. The operating thesis was that the government is going to flood the system with liquidity, which can only lead to inflation. In normal times, I would agree with that statement and so would the markets. However, after a brief dive in June of ’07 bond prices have increased by 50% while yields are correspondingly lower. At these prices, most of the calls I get are from people either afraid to buy bonds or, people who can’t wait to sell them.

Currently, U.S. interest rate futures show the yield to maturity on long bond futures is around 3.375%. This equals a long bond futures price around 133.  The long bond had been consolidating for nearly a year as investors expected the yield curve to steepen as the recovery got underway. The general action in the market was to buy short- term debt and sell long- term. However, as the recovery has failed to find its legs and the global governments prepare for a lengthy slow down, we’ve seen a substantial build in commercial trader’s acquisition of long -term debt. As much as people dislike the idea of 3.375% interest rate, there is the opportunity to gain some price appreciation in the interest rate complex.

(As I’m proof reading this, Professor Jeremy Siegel of the Wharton School of Economics is on CNBC arguing that the current yield on government bonds do NOT represent a good investment for most portfolios. My argument is for price appreciation in the futures market, not yield accrual in the cash market.)

The scenario is this. The 30 yr. T-Bond futures have a margin requirement of $3,375. The contract is a 6% coupon with a face value of $100,000 dollars. This market is currently trading at a price of 133 with a 3.375% yield. The consensus is that the bond market will continue to climb in price, which means lower and lower yields ahead. We stated earlier that Japan has gone through deflation and their government operated at 0% interest for years. In spite of the governments 0% stimulation plan, Japanese Government Bonds never traded below a yield of .5%. If we are to assume that our situation is going to take longer to sort itself out than we first expected, then it is safe to say that we will edge closer to the 0% rate that our Federal Reserve Board is already defending. If 30yr. T-Bond futures were to drop to 2% yield to maturity, that equal a futures price of 165.59 or, approximately a $30,000 gain on the contracts $100,000 face value. A futures price of 190.03 which corresponds to a 1% yield to maturity would equal a gain of $57,000 per contract. Finally, to match the Japanese Government Bond’s all time low yield of .5%, 30yr. T-Bond futures would have to trade, in price, up to 204.53. This would equal a cash gain of approximately $90,000 on the $100,000 face value.

Bonds should remain a part of one’s portfolio. Through the use of the 30yr. Bond futures, the market’s price gain can be captured as yields continue to fall without having to commit a large portion of available cash. The $3,375 initial margin requirement to control $100,000 face value Treasury bond contract helps illustrate the beauty of the commodity markets. Since it is extremely rare for a trader to be instantly right the market, a sufficient cash cushion should be kept to absorb day to day price fluctuations.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Commercial Traders Ahead of the Game

The Commodity Futures Trading Commission publishes a weekly report entitled, “Commitment of Traders Report.” This report totals the positions by all major commodity market players and breaks them down into a few important categories. The category that is most predictive of future moves in the commodity markets is the Commercial Trader category. This group is made up of people who are hedging their need for the physical commodity to meet future production as well as the producers of physical commodities who are trying to get their future production sold at the best possible prices. These are the professionals whose livelihood depends on their ability to ascertain value in their particular markets. Following their behavior in the commodity markets is very similar to following the reportable insider trading in the stock market, in which employee transactions of large amounts of stock must be reported to the Securities Exchange Commission.

Following the commercial trader category provides keen insight into the commodity markets. Some examples are seasonals, divergences and macro economic expectations. Comparing year over year action against established seasonal trends can allow traders to catch a glimpse into the expected strength or weakness of the current cyclicality in a market. Crude oil typically experiences its greatest strength from early July through the end of August. This year, the commercial buying came in just as expected and the market made its most recent low on July 6th and has rallied from $71.50 to almost $83 dollars per barrel.

Divergences appear when a market makes a new multi month high or low that is not validated by the commercial traders’ actions. For example, today’s news that China’s property market is cooling off has already been reflected in the market by commercial traders who have sold this rally relentlessly and capped the rally for six straight trading sessions under $3.40 per pound.

Both of these examples tie into the macro economic expectations of commercial traders. The seasonal rally in crude oil has been cut short by heavy commercial selling over the last two weeks due to expected softness in global crude oil demand. Recent energy reports show that gasoline levels here in the U.S. are at a six-week high and our refineries are trending toward decreased capacity utilization. Furthermore, China, the world’s largest crude oil consumer, has decreased their imports 15% since June.

The capping of prices in the copper market by commercial traders is further evidence of an expected economic slowdown. Commercial traders who follow the markets that provide their livelihood are among the first to know and analyze important information. They were aware that China’s copper and iron ore shipments are down for the first time in four months and that their crude oil consumption is 15% lower for July.

Finally, we can extend this same analysis to commercial positions in other actively traded markets as well. The disappointing projections are for a weaker stock market, low bond yields and higher agricultural prices. The build up of short positions in the stock market over the last three weeks has been considerable. Clearly, professional traders’ expectations of the stock market are negative. This can be partially verified by the buildup of short maturity debt. Interest rate futures across the strip expect to see continued buying even in the face of added government stimulus and a weakening U.S. Dollar. In fact, one of the most fundamental traders of all time – Warren Buffet, has shown that they are increasingly buying short- term treasuries. This omen portends the possibility of profiting on a flight to quality as people pull money out of a falling stock market and place it in U.S. Treasuries for liquidity and protection.

Finally, professional traders in the grain markets have been making their stand in two ways. First, buyers of grains are supporting higher and higher floor prices. This means the folks at Nabisco, Quaker Oats and Frito Lay are all expecting the growing overseas middle class to put a squeeze on the United States’ ability to remain the, “bread basket to the world.” Sellers of grains, on the other hand, are more willing to let the markets spike higher and higher before capping their profit potential. This was witnessed over the last month as overseas growing issues forced U.S. grain prices up 28% in corn, over 50% in oats and the price of wheat nearly doubled.

Trading alongside of the commercial traders has been quoted as, “Following the elephants.” This provides three benefits. Their actions are reported weekly, making their path easy to find. They cut a wide enough swath through the market to allow us to slip in and out at our convenience. Finally, they offer a tremendous amount of protection. Trading the markets is hard enough on your own. Why not allow the elephants to guide you?

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.