A Better Hedge with Gold and Silver

The financial markets are back to their news event driven, schizophrenic selves. The European Union concerns remain even after Greece’s recent election. Cyprus is on the short list for coming defaults. Spain has formally asked for a bailout. Meanwhile, here in the U.S. the Federal Reserve has just expanded Operation Twist by another $267 billion. The expansion of Operation Twist goes into effect two weeks after we discussed the steepening of the U.S. interest rate futures yield curve. The increasing volatility of the stock and bond markets make the buy and hold mantra a much tougher proposition to follow. However, the full, “risk on, risk off,” nature of all hard asset classes makes alternative investments just as volatile.

This volatility has extended to the precious metals markets. Those who’ve bought gold as a hedge against falling equity prices, dollar depreciation and higher interest rate expectations have been disappointed as both equities and gold have declined in what has morphed into a deflationary environment. The European situation appears as though it will drag on forever. China is doing what it can to provide a soft landing for their slowing economy. India is forecasting much lower growth as well as a stalemate in political reform. Consequently, we’ve seen the S&P 500 decline by nearly 7% since the March highs. Meanwhile, the gold hedge has lost slightly more at 7.5% over the same period. Ugh.

It is time to rethink the idea of hedging portfolio risk through outright ownership of alternative asset classes. A deflationary environment negates the negatively correlated price structure we expect out of the gold vs. Dollar and equities relationship. This becomes especially tricky when the long-term outlook becomes increasingly inflationary as the direct result of government and banking policies being enacted both domestically and globally.

A top in the silver market preceded the recent decline in the gold market by five months. This also coincided with the peak in the gold versus silver ratio, which priced gold at 32 times the price of silver. Silver was trading at just under $49 per ounce while gold was at $1560. The last time gold was that cheap relative to silver was 1981. The recent high for this spread was 80 during the height of the financial crisis in October of ’08.

Commercial traders also appear to be moving to a silver biased position. Commercial traders doubled their net positions when it appeared that the metal markets were building a saucer base and the markets’ participants had favorable expectations of the first Greek elections and Eurozone resolution. However, as June approached and Greece was unable to form a coalition government after the first round of elections and Spain’s interest rates began to climb on the open market, it became clear that, “risk off” was the correct play. As expected, commercial traders shed approximately 16% of their gold. The shift to silver became obvious when the Commitment of Traders Report showed virtually no change in their corresponding silver position. This places them squarely in camp of, “silver to gain on gold.”

Silver is far more volatile than gold. Silver will appreciate more in a, “risk on,” environment and will also decline more in a, “risk off,” scenario. It is the added volatility of the silver market that allows us to price it competitively. The highest price gold has reached may be 80 times the price of silver but, a more realistic number is somewhere just north of 60. In fact, there have only been 17 months out of the last 96 that gold has closed at a value greater than 65 times the price of silver. Therefore, the current ratio of 58 places the spread well within the value area.

Thus far, we’ve discussed the gold and silver relationship on a 1 to 1 basis. The ratio that we’ve been using is based on an ounce of gold and an ounce of silver. However, the futures markets do not trade single ounce contracts. Therefore, we must construct a spread that equalizes the contract sizes and meets the goal of owning silver and selling gold on an ounce for ounce basis. The least common denominator in the futures market is 1,000 ounces. The NYSE Liffe exchange offers a 1,000 ounce silver futures contract, which is the smallest listed silver contract. This can be paired with 10 contracts of the standard COMEX, 100 ounce gold futures contract to create a spread owning 1,000 ounces of silver and selling 1,000 ounces of gold. This spread will help ensure inflation protection as well as safe haven concerns and diversification away from the equity markets while limiting the schizophrenic effects of a, “risk on/risk off,” news and political environment.

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 of loss in investing in futures.

Soybean Bulls are Back

 

Spring’s early warmth is quickly turning into summer’s
furnace. The same weather that allowed farmers to get their planting done at a
record pace is now threatening the welfare of those same crops. The dry weather
is also fueling a rebound on the heels of May’s declines. The declines of 14.5%
in July corn and 12% in July soybeans helped trim the record speculative
positions as stated in the Commitment of Traders Report in both of the markets by 25%. The markets have reset and are now
being driven by the weather and crop reports.

Grain traders, farmers and end line users have access to
more data than perhaps, any other market. Ag Trader Talk reported that soil
moisture for the Midwest grain belt is the second driest since 1895. Precipitation
models are available for every major production region in the world. You can access
Chinese, Australian, Russian and South American weather reports as quickly as
you can Google. The dry soils will have a material impact on the double crop beans
in the Eastern Corn Belt, which will have tough time getting planted at all.
This solidifies the bean strength over corn weakness thesis we’ve been
operating under since the first planting reports.

The USDA publishes many regular reports. The weekly Crop Progress Report tracks the main producing states’ crop condition rated as poor,
fair, good or excellent. The recent drop in soybean crop condition, to the
lowest levels for this time of year since 1993 fueled a single day rally of
3.5%. There is also some correlation between the mid-June Crop Progress Report
decline in soybean conditions and the final yield for the soybean market. The
soybean market needs to hit trend line yields near 44 bushels per acre.
Anything below this would seriously compromise the stocks to usage ratio, which
continues to flirt with record lows due to strong overseas demand. In fact,
global demand has outpaced supply in three of the last five years.

China’s impact on the grain markets cannot be
underestimated. The growth of their livestock industry to meet the growing
appetites of their economically empowered middle class can be seen in the
dramatic increase in their grain usage. For example, China used more corn for
animal feed in 2011 than they used as an entire country in 2004 and their
soybean usage has more than doubled during the same time period.

Fortunately, the USDA tends to underestimate the corn crop
in the June Crop Report. Recently, the margin of error has pushed towards 300
million extra bushels by harvest. Commodity bulls may be jumping the gun on the
early summer’s effect on end yield, as well. The Commodity Weather Group’s
studies show that the Mid-June Crop Progress Report is an unreliable yield
predictor for the corn market. This is just as important because the corn
market also started the year with little in reserve as last year’s usage far
outpaced corn’s below trend yield. This is part of what led to the record corn acreage
being planted this year.

Modern farming practices continue to push the efficiency
envelope. I think this is one of the main reasons why there is little
predictive value in comparing current conditions to those more than 100 years
ago or, even 20 years ago. News reports may sensationalize the use of
genetically modified seeds and the impact of fertilizer on the ground water
supply but the fact is, without the continued advancement of the agricultural
sciences the world would rapidly experience an exponential explosion in food
costs.

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 of loss in investing in futures.

Fear and Inflation

    

The bailout of Spain has begun and the market’s reaction suggests that it has found little comfort from the 100 billion Euros that have been allotted to backstop their debt. The initial drop in Spanish yields was short lived as the market closed nearly where it had begun the day. Immediately the talk turned to Italy’s ability to maintain serviceable interest rates on their debt. Followed immediately by Ireland leveraging the situation to their advantage by seeking to renegotiate the terms of their bailout to match Spain’s favorable terms. Otherwise, Ireland may simply default. The net result was the continued evacuation of money from the European Union and into the U.S. Dollar and U.S. Treasuries. The flood pushed Treasuries to record low yields.

We are at a critical juncture in the decades long Treasury rally and I believe that we are nearing the top. The political unrest overseas has the ability to accentuate the last leg of this move and create a major spike high and the CFTC’s Commitment of Traders (COT) reports show unequivocally that major bets are being placed on both of these outcomes. This creates the setup for a steepening yield curve going forward as short-term rates decline on a flight to safety while long-term rates begin to more accurately reflect the inflationary nature of the monetary policies being enacted by both the European Union and us.

The major market players’ actions have begun to crystallize since the beginning of March. This started the Dollar and Treasury rallies in earnest. We’ve seen a 7% rise in the Dollar and a 200% increase in the commercial traders’ position. Meanwhile, Treasury price rallies of 4.5% in the 10-year Note and 10% in the 30-year Bond have pushed the futures markets to record low yields of 2.107% and 2.608%, respectively. These price rallies have had the full support of commercial traders as they loaded up near the March lows, increasing their positions by 65% in the 10-year Notes and 122% in the 30-year Bonds.

There are two important things to notice in the preceding paragraph. First, is the disparity between the price rallies of the 10-year Note and the 30-year Bond. This provides a feel for how much more volatile the interest rate picture gets as it moves out on the timeline. Secondly, it demonstrates how well the commercial traders forecast price swings in the U.S. interest rate futures. Both of these facts are supported by their winning trading accuracy of 73% in the 10-year Note and 64% in the 30-year Bonds via the COT Signals nightly trading signals.

Market sentiment and the actions of the large Treasury traders changed substantially towards the third week of May. This is when it appeared that the equity sell off might have halted. The tell came when equities continued to slide into June and commercial traders shed less than 20% of their long 10-year positions with the expectations of continued low short-term rates while simultaneously selling off more than half of their 30 year Bond position to match their expectations of inflation in the future.

Successful traders don’t make a living by catching the reversal of a 20-year trend, nor do they ignore the fundamental thesis of the politics of the day. The current picture is quite clear that politics must keep short-term rates near zero as the European banking system absorbs the full brunt of a panicked public. Traders are also keenly aware that what is borrowed today must be paid back in the future. Therefore, traders are using the market’s current volatility to calculate future interest rates that reflect where the global economies will be, rather than where we are.

Crestmont Research has a wonderful site full of scholarly research on both the equity and index markets. Part of their research in the interest rate field shows that the vast majority of times, interest rates will fluctuate by at least 50 basis points over every six month period at some point along the yield curve. We’ve already illustrated the volatility of the 30-year Bond. Putting their research to work for us provides a six-month volatility envelope in the December Bond futures with a high price of 154^20 and a corresponding low yield of 2.251% and a low price of 140^06 and a corresponding high yield of 3.251%. Clearly, commercial traders are signaling their expectations that the low price, high yield scenario is the one that plays out.

Link to annotated charts for this blog – here.

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 of loss in investing in futures.

Commercial Traders See Steeper Yield Curve Ahead

The weekends big news was focused on Spain and the regulated $125
billion bailout which delivered a brief respite to the embattled
physical commodity markets. The sigh of relief is only momentary as
physical sellers come back in to beat down the industrial futures
markets.We believe there are a couple of interesting developments
headed our way as the market sectors begin to separate and realign
their value propositions going forward.

Continue Reading

Sugar Based Ethanol Boost

Many markets, both commodities and equities declined substantially during the month of May. Two weeks ago, we mentioned that we were nearing fundamental value areas in certain markets. This week, we’ll make the case for a bottoming sugar market as well as its effect on the coming corn crop’s prices.

First, lets review the global ethanol market. The ethanol here in the U.S. is made from corn and the finished product is, “anhydrous ethanol.” Anhydrous ethanol is blended with gasoline. The end result is E85 at the pump. E85 is the maximum ethanol blend allowed. It consists of 85% ethanol and 15% gasoline. The typical ethanol blend here in the U.S. is up to 10% ethanol and 90% standard gasoline. The mixture of E15, which will boost ethanol content to 15% was just approved in 2010 for car models 2007 and newer.

The primary source of ethanol on the open market is made from sugar cane. Brazil is the world’s largest sugar producer and is responsible for about one third of global production. Brazil’s sugar cane derived ethanol is a much more efficient process both in terms of the finished ethanol and product cycle regeneration. Brazilian ethanol production also produces, “hydrous” ethanol. Hydrous ethanol is used in 100% ethanol fueled vehicles, which we see as E100 as well as any Flex-Fueled vehicle.

Ethanol production from sugar cane is much more efficient than production from corn. Ethanol production from sugar produces about 5,166 liters per acre while production from an acre of corn yields only 1,894 liters. The self-sufficient energy mandate that has been the guiding force here in the U.S. for the last 10 years or so has allocated nearly 35% of this year’s corn crop to the production of ethanol. So, why are we basing our future on such an unfeasible model? The answer lies in the government subsidies going to the farm and energy industries. This year marks the end of the $.45 per gallon ethanol subsidy as well as the end of the $.54 tariff we impose on ethanol imports. This combination fostered the proliferation of business entities whose primary profit center was the exploitation of a protected and subsidized market to the tune of $.99 per gallon.

Both of these policies expired at the end of 2012. The price swing of nearly $1 per gallon made U.S. subsidized ethanol inventories a bargain on the open market. Ironically, this led to Brazil being the number one importer of corn based, U.S. ethanol on the global market. Our subsidized production paid for by the taxpayers was sold at the discounted price to Brazil by the blending stations earning the tax credits.  It is important to note that further corn subsidies also exist here to the tune of $3.5 billion to corn farmers in the U.S. and $0 subsidies to U.S. sugar cane growers.

The loss of the ethanol subsidy combined with the remaining direct government subsidies for growing corn should shift total global production of ethanol from corn to sugar. The interesting point will be how many corn based ethanol plants here in the U.S. go the way of Solyndra as the poster children of a misdirected governmentally mandated and subsidized pipe dream. Meanwhile, excess sugar production over the current growing season should be digested, as it is shipped world wide for foodstuffs while Brazil works through their own domestic surplus. This shift will allow the largest corn crop ever planted to be diverted to traditional uses. Furthermore, we can track the huge imbalance in the sugar market between commercial trader and the small speculators through the Commitment of Traders Report. The net effect will be falling corn prices, perhaps under $5 per bushel and a sugar price base around $.185 per pound.

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 of loss in investing in futures.