Our focus on the commercial trader population within the Commodity Futures Trading Commissions’ (CFTC) weekly Commitments of Traders (COT) report is based upon the premise that these people are some of the most well connected members of today’s financial world. Much of the weight we give them is based on years of watching their positions build and decline in conjunction with the economic news of a given market. Their timing is uncannily accurate. Therefore, when their actions forecast a given scenario ahead of an important news event, we take note. When the news, like this morning’s unemployment report, moves the market further against their position, we REALLY take note.
Gold, interest rates and the stock market have a very interesting relationship. Normally, declining interest rates are good for business and bad for gold. Post 9/11 and housing bubble, zero interest rate policies (ZIRP) created an artificial situation that fractured this relationship rendering it virtually useless over the last decade. This began to change last summer when the Federal Reserve Board stated that they would begin slowing the stimulus they’ve provided to the economy thus allowing interest rates to gradually rise. These relationships have begun to sort themselves out over the last three quarters and may actually be telling us something about the current pricing in the gold market.
Successful trading pits two diametrically opposed ideas against each other and forces the trader to assimilate them into a cogent plan of action. First of all, everything we know, we know from history. We constantly relate the market’s present status to something we’ve seen in the past whether it’s fundamental, technical or pattern based. Secondly, we’re asked to project the implications of the current market’s structure into the unseen future. This week we’re going to discuss the implications of applying historical knowledge of the interest rate complex towards the deployment of mechanical models designed to take advantage of rising rates.
There are two primary steps to this process. Our first step is through analogous research. Analogous research begins when a present situation is recognizable because it looks or, behaves similarly to a pattern or collection of fundamental data that the trader has already experienced. The simplest version is the gut instinct, “You know, this market just feels like…….” A more quantifiable version falls along the lines of, “The last time these factors were in place, the market did…..” Analog trading is the primary basis for pattern recognition. The more often a certain pattern is seen and its results are predicted the more easily they are recognized and traded in the moment.
Empirically applying analogous research to the current interest rate sector yields the conclusion that monetary policy is far more likely to tighten than ease further. Sixty years of Prime interest data yields some ideas of what we can expect if history is any precursor to the future. First of all, rates have been abnormally low for an abnormally long period of time. The last time rates were steady for this long was 1960-1967. The Federal Reserve’s Prime rate has been at 3.25% since January of 2009. More importantly, it has been in a downward trend since August of 2007. A trader’s primary concern is always the trend.
The trader’s next objective is determining a target. These require both time and prices. Over the last 60 years once interest rates begin to move, they move by 73% on average before their peak or trough is reached. Furthermore, it takes an average of 30.6 months for the move to be completed. The extremes over this period include a move as small as 14% in as little as six months to more than 200% over the course of three and a half years. Throwing out the largest and smallest moves in both time and distance leaves us with an average interest rate move of 64.5% in 28 months. I think this blows a hole in the, “bonds are less volatile,” investment theory.
Anecdotally, there have been many headlines and news releases that should be forewarning us that a change in monetary policy is coming. These include comments from Fed Chairman Ben Bernanke as well as large investment managers. Perhaps the most noteworthy of which is Pimco’s decision to start offering access to hedge funds as it moves away from the bond business. Bill Gross has arguably been the most successful bond investor of all time. He has ridden the 30-year bull market in bonds up to $2 Trillion in assets under management. When the King leaves the table it’s a good clue that the free meal is over.
The case has now been made for what to expect out of interest rates as well as the time frame in which we expect it to happen once it begins to unfold. This led me to updating previously deployed interest rate models whose effectiveness became limited due to the artificial manipulation of rates following the economic meltdown of 2008. The simplest model is based on the DCB Bond system, which was published in Futures Truth in 2000. This model basically doubled its initial investment between 1995 and September 11th, 2001. The original version of this program traded both sides of the market and has fluctuated in and out of their Top 10 Bond systems since its publication nearly 14 years ago. Meanwhile the long only version posted a new equity high last June and has been flat for the last year.
Trading program technology has advanced substantially since then. We are currently developing programs using a neural network and selective data slices from rising interest rate environments. The main benefit is that we can train it on the type of market movement we expect it to see. The downside is that due to the small windows of time that rates actually move, we only have an average of a 28-month window to use for both in and out of sample testing per episode. The end result will be something traded on a shorter timeframe and will require closer monitoring during the trading day once it is deployed. Fortunately, the tighter timeframe looks like it’s going to help keep risk in check as well. This is how we intend to use history to prepare us for the future. The only certainty in trading is that nothing lasts or, works forever. Define your criteria and trade within your expectations.
The Eurozone debt concerns have finally taken their rightful place as a daily front -page news story. Tuesday, Spain brought 2.5 billion Euros to market in 12-month bonds. The average rate for the auction was 3.45%. This is 45% higher than previous month’s auction rate. For the sake of comparison, it’s hard to find a 12-month CD over 1% here. Wednesday, 20,000 Grecians rioted in response to the latest round of austerity cuts. Finally, European Central Bank President Jean -Claude Trichet is calling for an expanded role of the bailout fund. These headlines all echo the same theme…uncertainty.
Uncertainty is a bigger impediment to fully functioning markets than fear or, greed. Uncertainty prevents planning and prevents action. While Europe digests their own financial crisis, we can take a look at the effects of our own actions here as well as what to expect in the coming months.
Throughout the late summer and into fall, many leading analysts suggested that the domestic stock market was a much better investment than the domestic bond market. This includes people like Warren Buffet, James Paulson and Alan Greenspan. Their general assertion was that the effects of the loose monetary policy put in place to provide liquidity and jump- start the economy was holding interest rates at artificially low levels. Therefore, the risk premium, which compares investing in stocks versus bonds, had swung in favor of equities. The fourth quarter has clearly proven this to be correct with the stock market up 9% so far in Q4 while the 30yr. Treasury bond has declined more than 9.5% in price.
Most of this rally has been based on the unwinding of the fear and carry trades. Investors must constantly balance yield versus safety. Lately, the investment world has become virtually unmanageable to the individual investor attempting to figure out what the global leaders will put into play, how it will affect their portfolio and finally, what actions can be taken to capitalize on that analysis if it is correct. For example, it was generally accepted that the domestic stock market, metals markets and the U.S. Dollar could not simultaneously trade in the same direction yet, that has been the case of the fourth quarter. In fact, a decline in commodity prices combined with a rise in borrowing costs would put a real squeeze on the carry trades that have been placed over the last two years.
One solution to this puzzle is to focus on individual pieces. Sometimes, we don’t have to know what the final picture looks like. Eventually, if we keep putting the pieces in the right places, the picture will take shape. Therefore, some of the assumptions we will be working with are:
– The U.S. is ahead of Europe in dealing with the financial crisis.
– The U.S is still the largest safe haven economy.
– Euro weakness will make the Dollar seem strong by comparison.
– Developing Tiger countries are the engines driving global growth.
These ideas will continue place us on the long side of the commodity markets, while trading both sides of the Stock market and the U.S. Dollar. The markets should become less predictable and volatility should increase as the risk premium between the currency, equity and commodity trades continues to tighten. This will place many asset classes on equal footing and leave alpha to be gained only through the careful examination of the individual issues within those asset classes.
Out of the 36 markets that we track on a daily basis, 25 of them are facing negative commercial trader momentum. As we discussed a couple of weeks ago, some of these markets are near all time speculative limits. In fact, crude oil just set a new record for speculative long positions this week. This means that professional money managers are putting money to work buying crude oil while the people who produce it are selling all they can. The ability to follow the money flowing through the individual commodities provides a degree of certainty. This allows us to take action, using bottom up, micro economic analysis while the people at the top are still trying to figure it out on a macro economic basis.
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.
Analyzing the markets requires a combination of quantitative and correlational research. It’s easy to track jobless numbers, productivity, crop acreage or crude oil stocks. These numbers help define the fundamental supply and demand of the price equation. Trading, actual trading, is different from quantitative analysis because we are looking for actionable clues to imminent price movement and what will trigger it. These are the support and resistance numbers, spread ratios like gold to oil or, corn to beans. These are the chart patterns like head and shoulders, bull and bear flags and reversals that people watch for confirmation of the impact of their quantitative analysis.
Correlational research is an integral part of both fundamental and technical analysis. How many times have you heard the phrase, “Flight to quality?” This phrase is based on money being pulled out of risky assets and placed in safer asset classes like bonds, money markets or, the safe haven of gold. Investors are willing to settle for the bird in the hand rather than chase after the two in the bush. We also see this behavior in the inflation markets. How many times have you heard gold touted as an inflation hedge? Investors concerned with rising interest rates, a falling dollar or financial panic frequently place a percentage of their portfolio in gold because theoretically, its price should rise with inflation and panic.
Currently, there are several market relationships that are bucking their theoretical correlations. Positive and negative correlations provide clues into market behavior and when these relationships get out of whack, we should take notice. We can tie the examples mentioned above to two distinct market relationships. The flight to quality is typically measured as money coming out of the stock market and flowing into the bond market. This is visible on charts as a falling stock market and a rising bond prices. However, my application of flight to quality is based on the relationship between the stock market and the volatility index (VIX). The VIX measures market fear. The more fear there is in the stock market, the more anxious traders should be to pull money out of it. The typical relationship is for the VIX to rise as the stock market falls. Tracking the relationship in this manner means that I don’t have to search out the final destination for funds coming out of the stock market. It is clear from the chart below that there was far less fear in the stock market when we made the new lows in July than there was when we made the lows of the, “Flash Crash” in early May or the lows at the end of May when the VIX peaked at 48. The correlational assessment of this relationship suggests that there was far less fear in the market when we made the July lows and therefore, the stock market outlook may not be totally bearish.
The second chart illustrates the inflation relationship between U.S. Government bonds and the price of gold. Typically, this is an inverse relationship. We see treasury prices fall as gold rallies. This represents investors’ view of future inflation. Gold is purchased as a hedge during inflationary times and sold off in times of economic stability or falling interest rates. Clearly, we are not witnessing the typical relationship between these markets. The bond market is pointing towards lower and lower rates while the gold market has also enjoyed a considerable rally. An important point in the gold chart comes at the start of the downtrend. The stock market made its most recent low on July 6th. This is two days after the gold market began to sell off. In a panic situation, such as the stock market taking out the May lows, one would expect to see the gold market rally. This is especially true in a market that has enjoyed the strength of its current trend and was sitting so near its highs. The stock market’s sell off should have provided the catalyst to move gold ever higher. This is an important divergence. When markets behave abnormally, we must sit up and take notice.
Unfortunately, I have little to offer as an answer to this riddle. Over the last few months, I’ve seen other relationships breakdown as well. The U.S. Dollar typically moves opposite the oil market. However, oil has remained stagnant, in spite of oil’s seasonal strength and a weak Dollar since early June. Finally, the Commercial Traders that I track through the weekly Commitment of Traders Report have shown large and contradictory moves. Commercial momentum in the gold and stock markets continue to build. These two inversely related markets are continuing to see inflows of capital from far smarter men than myself. Just to complicate matters further, I have also seen a significant build in momentum going out on the term rate structure. This means that big money is flowing from nearby treasuries and into longer dated treasuries. These moves, charts and relationships should provide for an interesting third quarter. Hold on tight and feel free to share your thoughts.
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.