This week will be a short myopic view of the internal workings of the interest rate futures market sector focusing on a potential short selling opportunity in the 10-year Treasury Note futures.
The Commitment of Traders report published weekly by the Commodity Futures Trading Commission breaks down the weekly market participants into several categories. In the age of big data, we reach a point where it’s easier to collect than it is to make sense of. We keep it simple at COTSignals.com by focusing our analysis on the commercial trader category of the Commitment of Traders Report. Subjectively, it makes sense that the people with a hand in producing or, consuming a given commodity have a fundamental sense of value that speculative traders simply lack. Furthermore, producers and end line users of a given commodity base their actions on the best collective models and strategies focused on their singular market. Quantitatively, we’ve proven the correlation and predictive value of their actions time and again.
We began the week with Bond market analysis for TraderPlanet. We looked at the tremendous and rapid build in the commercial trader position noting that the recent sell off may be nearing exhaustion. Based on Thursday’s reversal and ECB/IMF/Greek hope quickly deteriorating, we feel the short-term bang for the buck may be best on the long side of the market.
Tuesday, we focused on, “A Pause in the Yen’s Destruction.” We noted the rapid application of the Prime Minister and Bank of Japan’s plan to monetize their debt in a last ditch effort to reflate their economy. Like the Bond market, this market has seen tremendous and rapid commercial trader buying as the Yen fell to Y120 = $1.
Finally, we looked at the disconnect between nearby crude oil prices and current fundamentals. It’s hard to get bullish about supply cuts a year out when current inventories are the highest they’ve been in 80 years as we noted in the Energy Information Agency’s, ” Summary of Weekly Petroleum Data.”
Read – “Sell Crude Oil at $65 Per Barrel.”
Looks like we’re batting .500 for the week with a loss in the bond market being more than offset by the profits in corn. Meanwhile, our primary piece uncovered a nice pattern in the crude oil futures that we’re still waiting to take action on.
Free 30-day trial of nightly trading signals based on the Commitment of Traders Reports.
The story in, Bonds Creeping Towards Lower Yields, which was published at TraderPlanet still holds. Commercial traders, while roughly neutral in their current position, have rapidly purchased more than 17,000 heading into this week’s trading. This buying should help the support around 140^00 hold as the market makes some type of run at the October highs.
Mechanical COT Signals’ portfolio equity curve tracked by Futures Truth.
Other Sample Portfolios
Tuesday’s corn futures trade for Equities.com combined classic Commitment of Traders’ analysis along with an inside bar trigger to enter the trade. Sometimes, it works like a champ. It’s a high percentage trade and it played out well.
Finally, our main piece required eyeballing more than 20 years’ worth of commercial trader activity in crude oil futures. In, “Time to Buy Crude Oil’s Decline” we discussed a very specific pattern that we’ve only found eight examples of in the crude oil futures. More importantly, this pattern’s predictive power has been quite strong. Read the full piece for details.
The bulk of my Commitment of Traders research has gone into creating COT Signals.
The multi-year bond rally has continued unabated. Therefore, it’s no surprise that our mechanical, long only trading program following the commercial traders in the bond market has had a good year winning 7/8 trades as you can see on the chart below, for net profits of more than $5,000 per contract.
The current setup suggests that this roll should continue.
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.
Every market crash or bursting bubble is like the ice cream truck calling kids to the street. Portfolio managers and re-balancers know they get the opportunity to truly be heard only when something goes wrong.
Most people live their lives reacting to new stimulus. If something hurts, they don’t do it again. If something works, there’s no reason to change. Portfolio managers attempt to anticipate areas of pain and mitigate that pain wherever possible. However, there are times when efficient portfolio analysis, modern portfolio theory and just plain common-sense investing will still force one to endure periods of pain.
Portfolio composition is usually based on a collection of assets that tend to relate to each other in a predefined and expected way.
There are three basic relationships:
— Positive correlations: Two asset classes rise or fall together, predictably.
— Negative correlations: One class rises when the other falls and vice versa, predictably.
— Non-correlational: No predictable relationship.
The right balance of these relationships across multiple asset classes will smooth out returns and help to insure the predictable performance of one’s portfolio.
There’s an old saying from statistics 101: “Correlation does not equal causation.” We can measure how markets move relative to each other, but without understanding their relationships, we can’t say for certain what caused what. Sometimes, understanding “why” has a bigger impact on one’s portfolio than the actual mix of assets.
Last week we saw many markets fall. The stock market is lower, as are precious metals, bonds, grains, coffee, sugar, cocoa, crude oil and the energy markets. Many of the classic market relationships people use to balance their portfolios failed to behave in the anticipated manner and did not balance the risks associated with investing. Markets can and do, behave in unanticipated ways.
Commodity markets have been trending toward generally higher prices. The stock market has also had a nice rally and is up more than 9 percent since Labor Day. During this time, the Federal Reserve Board also announced a second round of quantitative easing to keep interest rates low and weaken the U.S. dollar. Consequently, bonds have rallied in price while the dollar has fallen.
The sudden about-face in many of the markets is twofold. First, the news regarding Ireland’s financial health has become increasingly pessimistic. Ireland was on the financial default radar, along with Greece, more than six months ago. Ireland has been very proactive in implementing domestic austerity measures to rein in spending. Furthermore, Ireland has also steadfastly maintained its financial issues are limited to a few banks that became overleveraged during their own housing bubble.
Unfortunately, the European Union has the same fears about Ireland and Greece we did in the U.S. with our own domestic banks and that is that every bank was more overextended than initially thought, requiring an even bigger lifeline to maintain solvency. Finally, Portugal and Spain are also on the verge of financial insolvency themselves.
The second fear to hit the markets was China’s announcement Wednesday its economy may be overheating again. Rumors are circulating China may follow several banks in Korea in raising its interest rates to slow down inflation and thus, economic growth. The data coming out of China certainly reinforces the idea it may constrict lending in the near future. China has a published cap on the amount of money its nationalized bank will lend in any calendar year and it is quickly approaching that ceiling. The fears are also evident in China’s stock market, which has slid more than 5 percent in the last few sessions.
These two events combined to cause havoc in our domestic markets as they immediately unraveled the underpinnings of our market rallies. The Chinese news sucked the demand out of the commodity markets. China’s clampdown on inflation is pulling money out of the commodity markets and reducing overseas demand for raw materials. The news from Ireland and the European Union has the equity markets spooked. For many investors, the 50-percent correction in the equity markets from our own financial crisis is all too real and all too recent. Our domestic stock market’s rally and the quickly approaching year’s end makes it easy for many traders and investors to simply pull money out of the markets.
News events shock the markets and broadly sweeping economic forces create seismic shifts in market behavior. During these turbulent times, typical market relationships may fail to behave in the predicted manner.
As the Chinese economy becomes a first class consumer, we must accept our role as a supplier, rather than our historical position of end line consumer. As a supplier, we need to recognize the demand-needs of our trading partners. This is a broadly sweeping change that will affect the commodity markets for years to come.
News from Ireland and the European Union can shock the stock market, reawakening nightmares of 2008, but plans can be made to account for these events.
It does require proactive management of one’s portfolio. The old days of the passive hedge and allocation strategies may be gone.
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.
and Outlook – First Quarter 2009
by Van Hoisington
and Dr. Lacy Hunt
Over the next decade, the critical element in any investment portfolio
These propositions are intuitively attractive. However, they are
If inflation and interest rates were to rise in this recession, or in
A technically superior and more complete method of capturing the concept