The Gold/Silver Spread: Fool’s Gold Or a Golden Opportunity?

Gold/Silver Spread

Gold and silver are precious metals. The price movement between the two is highly correlated and silver has always been substantially cheaper than gold. Because of this, silver is often referred to as “poor man’s gold”.

Gold Silver overlay monthly

Gold Silver overlay monthly

Silver is typically more volatile than gold. Since silver and gold usually go in the same direction and silver typically moves at a faster pace, it stands to reason that the ratio between gold and silver will climb during a bear market and decline during a bull market.

The fundamental relationship, the strong correlation, and the volatility differences are all ingredients for spread trading opportunities.

The Ratio

Last week the ratio between gold and silver 70:1, which is the highest level it has seen since the spring of 2010. Based on what has occurred at this level before, we expect that things could get pretty exciting in the precious metals from here.

Gold Silver ratio 2002 weekly

Gold Silver ratio 2002 weekly

The last two times that the gold/silver ratio climbed to a multi-year high of 70:1 was August of 2002 and again in September of 2008. Both times, the ratio accelerated higher. The ratio surged to 80:1 by early 2003 and it rocketed to 84:1 in the fourth quarter of 2008.

Gold Silver ratio 2010 weekly

Gold Silver ratio 2009 weekly

Longer-term, these accelerations were the tail end of a move that preceded a major reversal. From the 2003 high of 80:1 the ratio plunged to a multi-year low of just under 52:1 in just over ten months. From the 2008 high of 84:1 the ratio plunged to a multi-year low of just under 59:1 in eleven months.

Either we should now be at the top of the gold/silver ratio and the bottom of the multi-month decline in precious metals…or else we are at the point where there is a blow-off acceleration in the ratio while gold and silver plunge to new multi-year lows.

The spread

On Thursday the February gold contract closed at $1,222.60. This puts the value of a 100/oz. futures contract at $122,260.00. The March silver contract closed at $17.48. This puts the value of a 5,000/oz. futures contract at $87,400.00. Therefore, the February gold contract closed at a premium of +$34,860.00 over the March silver contract.

Gold Silver spread 2009 weekly

Gold Silver spread 2009 weekly

On the weekly timeframe, the gold/silver spread peaked at an all-time high of +$34,525.00 in late December of 2008. After backing off $19k over the next several months, the spread eked out a slight new all-time high of +$35,125.00 at the end of May 2009. From there it backed off and established a double top at the 2008/2009 highs. The spread ultimately inverted and plunged to -$87,280 (premium silver) by the spring of 2011. That’s a decline of roughly $122,000 on a single contract spread!

Although the gold/silver ratio is at a level that could see a significant move in either direction, the gold/silver spread is testing a double top that was made at an all-time high. This is stiff price resistance. A reversal from here could start a major decline.

Trend Change Signals

Currently, a 100/oz. February gold contract is equal in value to roughly 7,000/oz. of March silver. A regular-size silver futures contract is 5,000/oz. and a ‘mini’ silver futures contract is 1,000/oz. Therefore, a trader can create a more equalized gold/silver spread position by comparing the value of a single 100/oz. February gold contract against the sum of the value of one 5,000/oz. March silver futures contract and two of the 1,000/oz. March ‘mini’ silver futures contracts. On that basis, here are a couple of setups that one could use to identify a bearish trend change for the February-March gold/silver (x7,000/oz.) spread:

First, a two-day close below the rising 30-day Moving Average (currently around -$6,651) would be a bearish event. The spread has not closed below the 30-day MA in over two months. In late May the February-March gold/silver (x7,000/oz.) spread made a two-day close below the 30-day MA for the first time in two and a half months. This signal was timely as the spread dropped roughly $10k over the following weeks.  Maybe it will work again.

February Gold March Silver (7,000 oz.) spread daily

February Gold March Silver (7,000 oz.) spread daily

Secondly, the February-March gold/silver (x7,000/oz.) spread rocketed past the April 30th top and prior contract high of -$5,324 in mid-September. Now that this price resistance level has been clearly broken, it becomes price support. Therefore, a close back under the April 30th top would negate the breakout and signal a bearish trend change.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 100 oz. February gold contract and simultaneously buying one 5,000 oz. March silver contract and two 1,000/oz. March ‘mini’ silver futures contracts if the spread closes below the rising 30-day MA. Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry signal.

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The Cocoa/Sugar Spread: Is Something Setting Up For a Trick Or a Treat?

Cocoa/Sugar Spread

Here in mid-September, all of the stores are gearing up for the Halloween season. Costumes, toys, decorations, and candy by the truckload are now overflowing the shelves. That got me to thinking that it might be a good time to take a look at the spread between the cocoa market and the world sugar market. I know I’m stretching things a bit with this one, but I just can’t help it…I have a sweet tooth!

Looking at the market price data since the early ‘70s, there appears to be some correlation between the price of cocoa and the price of sugar. These two ‘soft’ commodities have often trended together. However, there are plenty of times where the two markets diverged as well. The divergence would sometimes persist for a year or two at a time. Somehow, the cocoa and sugar markets would still manage to get back together.

Correlation without Causation

Although we see several time periods where cocoa and sugar trekked together through bull markets and bear markets, it is hard to pinpoint a strong fundamental relationship between the two markets. Oh, there is the obvious point that sugar is used to sweeten cocoa for consumption. The multi-billion dollar Hershey Company will certainly attest to that. However, sugar is also used heavily in ethanol production and cocoa is not. Furthermore, it is not likely that the crops of cocoa and sugar are affected by the same weather situations. The Ivory Coast is the largest grower of cocoa on the planet and Brazil is the world’s largest sugar producer. They are not exactly close neighbors.

Cocoa Sugar overlay monthly

Cocoa Sugar overlay monthly

Nonetheless, there is some sort of observable synchronicity between cocoa and sugar. Enough so that a daring (and well-capitalized!) spread trader might want to take a shot at it from time to time. You just need to be selective about when to do it.

Wait For the Extremes

As you probably have guessed by now, our philosophy is to wait for inter-market spreads to reach historic extremes before we start getting excited. This is because we want to find a spread relationship that is mean-reverting and then start looking for a reason to bet on a mean-reversion once it has neared or reached previously unsustainable levels. In other words, we like to bet only when the odds are favorable.

A cocoa futures contract controls 10-tons of cocoa and a sugar #11 futures contract controls 112,000 lbs. of sugar, so comparing the two can seem a bit tricky. To simplify things, we just convert the spread to the difference between the values of one cocoa futures contract and one sugar #11 futures contract.

Cocoa Sugar spread monthly

Cocoa Sugar spread monthly

Four decades of history indicate that a middle-of-the-road area for the cocoa/sugar spread is somewhere between +$2k (premium cocoa) to ‘even money’ (where the two contracts have the same value). The spread is historically ‘expensive’ when it reaches +$10k or higher and it is historically ‘cheap’ when it inverts and sinks to -$5k (premium sugar) or lower.

A week ago, the spread between the nearest-delivery cocoa contract and the nearest-delivery sugar contract surpassed the +$15k mark for the first time since the spring of 2010. There are only five other times in the last four decades when the cocoa/sugar spread has made it to +$15k or higher (basis the nearest-futures monthly chart). Each time the spread eventually reversed and dropped all the way back below the ‘even money’ mark. Perhaps this could happen again?

Normalize It!

For the last few years, cocoa has traded at nose-bleed levels not seen since the late 70s/early 80s. Price extremes in a market will certainly cause a related spread to hit extremes as well. Therefore, we filter the spread by looking at the ratio between the two markets.

Cocoa Sugar ratio monthly

Cocoa Sugar ratio monthly

On Friday the ratio between nearest-delivery cocoa contract and the nearest-delivery sugar contract hit a nearly six-year high of 2.16:1 (a cocoa contract is worth a little more than twice as much as a sugar contract). Historical charts suggest that a normal level is somewhere around 1.2:1. A ratio of 2:1 has only materialized a handful of times in the last few decades. Therefore, the high ratio level confirms our suspicions: the cocoa/sugar spread really is expensive! Spread traders should be looking for a setup to get short.

Trend Change Signals

Unfortunately, a spread between the nearest-delivery cocoa contract and the nearest-delivery sugar contract would mean that we have to use the December cocoa contract and the October sugar contract. This is a problem because the October sugar contract goes off the board in a week and a half. So we are going to focus our efforts on the March cocoa/sugar spread instead.

We see at least three possible technical setups that a trader could use to identify a trend change:

First, consider the basic bullish pattern of higher highs and higher lows. In the last six months, the March cocoa/sugar spread has only traded below a prior month’s low one time. Also, the spread has made higher monthly highs for five consecutive months. Therefore, a break of a prior months low would alter this pattern and indicate a possible trend change.

March Cocoa Sugar spread daily

March Cocoa Sugar spread daily

Second, the March cocoa/sugar spread has closed above the rising 50-day Moving Average every single day for nearly three months straight. A close below the 50-day MA (currently around +$11,602) for the first time since late June would signal a bearish trend change.

Third, consider zooming out to a larger timeframe to filter out some of the noise on the daily timeframe. The March cocoa/sugar spread has closed above the rising weekly 10-day Moving Average every week since the first half of May. A weekly close below the weekly 10-day MA (somewhere around +$12,150 starting on Monday) would signal a bearish trend change.

March Cocoa Sugar spread weekly

March Cocoa Sugar spread weekly

The weekly 10-bar MA is similar to the daily 50-bar MA since a weekly bar consists of approximately five trading days. However, a filtering effect occurs since a crossover of the weekly moving average requires an end-of-week close below the moving average. It will escape the possible whipsaw of a mid-week close below the 50-day MA that gets reversed a day or two later. This can come at a cost, though. If the 50-day MA is broken at the start of the week and the spread continues to plunge for the rest of the week, the spread can be significantly lower by the time the weekly trade signal kicks in. You have to weigh the pros and cons and decide what best suits your own style.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 10-ton March cocoa contract and simultaneously buying one 112,000 lb. March sugar #11 contract if the spread closes below the rising weekly 10-day MA or closes below the August low of +$11,216, whichever occurs first. Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry.

If the ratio between March cocoa and March sugar surpasses 2:1 before a reversal signal is triggered, we may revise the trade to short one cocoa contract against two sugar contracts. We will post an update is this occurs.

 

Cattle Crush Spread: Trade Signal Triggered

Cattle Crush Spread

Today a hypothetical trade for the blog was triggered in the 6:3:2 cattle crush spread. The position would have been created by purchasing six 40,000 lb. August 2015 live cattle contracts, shorting three 50,000 lb. April 2015 feeder contracts, and shorting two 5,000 bushel May 2015 corn contracts when the spread declined to -$8,000 (premium the sum of the feeders and corn). Initially, the exit strategy is to liquidate the spread on a two-consecutive day close below -$12,500.

Aug-April-May 2015 Cattle Crush spread daily

Aug-April-May 2015 Cattle Crush spread daily

Once this cattle crush spread clears the mid-July bounce high of -$802.50 we will have a breakout on our hands. This would trigger a Turtle-style buy signal. Keep a close eye on this one. We will have additional commentary if/when it happens.

 

Livestock Spread: Trade Signal Triggered

Feeders/Live Cattle Spread

On August 21st a short sale signal for the Nov-Dec feeder/live cattle spread was triggered. Theoretically, the blog would have sold one 50,000 lb. November feeder cattle contract at 207.35 and bought one 40,000 lb. December live cattle contract at 148.60 for a spread of 58.75 (premium feeders).

November Feeders December live cattle spread daily

November Feeders December live cattle spread daily

Today the short position would have been liquidated at a loss since the Nov-Dec feeder/live cattle spread made a two-consecutive day close above 64.80. Based on today’s close, the November feeder cattle contract would have been bought back at 225.60 and the December live cattle contract would have been sold at 160.00 for a spread of 65.60 (premium feeders). The theoretical loss on the trade would have been approximately -$4,565 per spread (a loss of -$9,125 on the feeder contract and a profit of +$4,560 on the live cattle contracts).

Trade Reentry Strategy:

Although shorting the break below the 50-day Moving Average was a losing proposition, the fact remains that the Nov-Dec feeder/live cattle spread is still a candidate for a short sale.

One thing that did not change is the price structure. The Nov-Dec feeder/live cattle spread just made a higher monthly high for the eighth consecutive month and it has not yet breached a previous month’s low since early February.

The blog will make a hypothetical reentry trade by shorting one 50,000 lb. November feeder cattle contract and simultaneously buying one 40,000 lb. December live cattle contract if the spread closes below the August low of 57.925. Initially, the spread will be liquidated on a two-consecutive day close .50 points above the contract high (currently 65.60) that precedes the reentry signal. If the trade does not trigger by the close on September 30th, the reentry criteria will be raised to selling a close below the September low.

The Cattle Crush Spread Is Getting Slaughtered! Is It Time To Buy?

The Cattle Crush Spread

Last month we talked about the spread between feeder cattle and live cattle. Now let’s make things slightly more complex and throw another factor into the relationship: feed costs. After all, the feeder cattle have to eat something to get fattened up for slaughter.

For the most part, corn is used for livestock feed. Therefore, the combination of feeder cattle costs and corn costs account for the lion’s share of the costs in a feedlot operation. The difference between the cost of the feeders and corn and the price that the live cattle are sold for is called the ‘gross feeding margin’. In the trading pits it’s also called the cattle feeding spread or a cattle ‘crush’ spread.

Building a Cattle Crush with Futures Contracts

At the Chicago Merc, futures contracts are available for feeders, live cattle, and corn. To create a position in the cattle crush spread, one must be long both feeders and corn and short the live cattle. Just like a feedlot operation, you ‘buy’ the feeders and the feed (corn) and then you ‘sell’ them as live cattle to the packers at a price that is (hopefully) greater than your purchase price for the feeders and corn. This is a forward crush spread.

Conversely, one can just as easily implement a ‘reverse cattle crush’ by buying the live cattle and shorting both the feeders and corn. One would do this if they thought that the productions costs (feeders and corn) were way too high and/or the end product (live cattle) was under-priced.

A feeder cattle futures contract controls 50,000 lbs, a live cattle futures contract controls 40,000 lbs, and a corn futures contract controls 5,000 bushels. Therefore, the quantities on the futures contracts for each market in the cattle crush spread will vary in order to replicate the workings of a feedlot.

An average feeder calf weighs about 750 lbs and an average steer (live cattle) weighs about 1,250 lbs. Therefore, the 50,000 lb feeder contract is the equivalent of about 66 calves and the 40,000 lb live cattle contract is the equivalent of about 32 steers. This means that a futures contract spread should have approximately double the amount of live cattle contracts as the feeder contracts in order to approach an equal amount of animals.

We also have to figure in how much feed is used. A rough estimate is that it would take about 50 bushels of corn to raise a feeder to a full-grown steer. So it would take approximately 3,300 bushels of corn to feed the equivalent of the 66 calves in a 50,000 lb feeder cattle futures contract.

Using the above calculations, one could construct a cattle crush position by spreading six live cattle contracts against three feeder cattle contracts and two corn contracts. This gives you twice as many live cattle contracts as feeder contracts and enough corn contracts to cover the approximate amount of feed for the feeder contracts.

The Right Delivery Contracts

It takes time for feeders to eat all of their corn and grow up into live cattle. To reach slaughter weight it’s a 4-6 month process. Therefore, the live cattle contracts in the cattle crush spread should be for a delivery date that is at 4-6 months later than the delivery date for the feeder contracts. The corn contracts should be as close as possible to the same delivery date as the feeders.

For example, if you are looking at buying or selling November 2014 feeder contracts you would use the December 2014 corn contracts and the April 2015 live cattle contracts. If you trade the April or May 2015 feeder contracts you would use the May 2015 corn contracts and the August 2015 or even the October 2015 live cattle contracts.

Historical Precedent

To gain a perspective of where the cattle crush spread has been and where it has the potential to go, we took a look at the monthly nearest-futures data since 1970. This cattle crush spread is set at a ratio of 6:3:2, meaning that it calculates the difference in the value of six live cattle contracts against the sum of the value of three feeder contracts and two corn contracts.

Importantly, you need to know upfront that this is certainly not perfect because it involves only the closest delivery contracts of the feeders, corn, and live cattle. It does not show the live cattle contracts that are 4-6 months out from the nearest-futures feeders. This gives us an imperfect historical reference. Nonetheless, the man with just one eye can still be the king in the land of the blind.

Cattle Crush spread (nearest-futures) monthly

Cattle Crush spread (nearest-futures) monthly

Notice that the cattle crush has been in a choppy range for decades. All trends seem to be short-term affairs that last a few months and then reverse sharply in the other direction. Over the last decade, a slight downward drift is evident as slightly lower highs and lower lows are evident.

It appears that once the spread drops under +$10k (premium live cattle) it gets close to a bottom. Conversely, peaks quickly follow trades above +$40k (premium live cattle). Whether it move toward the high or low end of the extremes, the spread always returns to somewhere around the +$30K mark, plus or minus $5k.

Ready, Set, and…Wait!

Once the 6:3:2 cattle crush reaches an extreme reading of +$40k and above or +$10k and below, a trading opportunity may be setting up. However, it is still not a green light to jump in. Recall that we are not trading the same delivery contracts for all three markets. The live cattle contracts need to have a later delivery than the feeders. Therefore, an extreme reading on the nearest-futures spread is a signal to investigate further.

An extreme reading on the nearest-futures chart prompts us to further examine the crush spread with an input of the correct delivery contracts (i.e. a live cattle contract that is up for delivery 4-6 months later than the feeder contract). Ideally, the crush spread you select should have at least three months until the feeder contracts expire. That way you have plenty of time for a trend to develop and mature before you have to start planning the rollovers. Also, you should still peek at the deferred spreads. Sometimes there are aberrations in the distant month contracts that are not found in the more liquid closer delivery contracts. This can heap an abundance of financial rewards on the diligent trader.

Due to the slight downward trend of the last decade, we would advise waiting for a price of $5k (premium cattle) or lower before getting involved with the long side of a cattle crush spread position. Let the novice traders take the higher priced, lower probability trades. Our objective is to consider only the high-probability, high reward-to-risk trade setups and ignore everything else.

Shooting Fish in a Barrel

A record corn crop in the US has brought feed prices down dramatically this summer. However, feeder prices have rallied even faster than the price of the live cattle as a supply shortage persists. This is due to the smallest cattle inventory in several decades after the 2012 drought slaughtered the livestock industry.

Feedlot profit margins have started to narrow considerably. Some feedlots are projected to be operating in the red starting in the fourth quarter. In the futures markets, some of the 2015 cattle crush spreads are negatively priced. Common sense indicates that this is not sustainable. Either the input costs (feeders and corn) need to drop or else the output costs (live cattle) must rise.

To that end, we are very interested in the crush spread between the August 2015 live cattle and the April 2015 feeders and May 2015 corn:

At yesterday’s closing price of 147.80, the value of an August 2015 live cattle contract is $59,120. The sum of six contracts is $354,720.

The April 2015 feeders closed at 216.80, yielding a value of $108,400 per contract. The sum of three contracts is $325,200.

The May 2015 corn closed at $3.59 1/2. This puts the value of a contract at $17,975. The sum of two contracts is $35,950.

Subtract the value of the live cattle contracts from the value of the feeders and corn contract and you get -$6,430. Notice that the output side (live cattle) of this crush spread is trading below the price of the input side (feeders and corn)! With the spread price currently inverted and ample time before deliveries (at least seven months), this just might be a lucrative buying opportunity shaping up.

Bullish Setups and Signals

The 2015 August-April-May cattle crush spread does not have a lot of chart history at the moment. Therefore, there is not a persistent trend on the charts that one could use to key off of for an upside reversal. Instead, we have to look for some sort of price pattern.

2015 August-April-May Cattle Crush spread daily

2015 August-April-May Cattle Crush spread daily

At the moment, a classic chart pattern may be developing: The famous Double Bottom. The 2015 August-April-May cattle crush spread posted a contract low of -$8,540 on June 27th, it bounced as high as -$802.50 on July 21st, and it sank to a low of -$8,387.50 on September 9th. If they hold, the similar lows from June and last week would set the formation. Therefore, one could buy against these lows. It is also possible that the spread may also decide to return to this area several times. A trader should risk a close well below this level in case it turns into a trading range.

The July high of -$802.50 is an overhead barrier that should also be monitored. A strong close above this level would put the spread at a level not seen in several months. This would be a classic breakout trade signal (think Donchian breakout, or “Turtles” style trading) that one could use to identify a bullish turnaround for the 2015 August-April-May cattle crush spread.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by purchasing six 40,000 lb August 2015 live cattle contracts and simultaneously shorting three 50,000 lb April 2015 feeder contracts and shorting two 5,000 bushel May 2015 corn contracts if this 6:3:2 cattle crush spread trades at -$8,000 (premium the sum of the feeders and corn) or if it closes above the July high of -$802.50, whichever comes first. Initially, the spread will be liquidated on a two-consecutive day close below -$4,500 below the entry price.

Euro Bunds vs. T-notes: Historic Highs = Historic Opportunities?

Interest Rate Spreads (Part II)

As mentioned in the post on the T-bond/T-note spread, interest rate markets have historically provided many good spread trading candidates. They trend well. And when the trend inevitably ends, the spread can often surrender all of the hard-won gains in just a fraction of the time that it took to accumulate them. Even more so when you are dealing with a mean-reverting spread that reached an extreme. Ergo, the old Wall Street saying that “the markets go up on an escalator and down on an elevator”.

Euro Bunds T-notes Overlay Monthly

Euro Bunds T-notes Overlay Monthly

Currently, the spread between the Euro bund and the US T-note has our attention. This is an inter-market Treasury trade with lucrative possibilities. We are playing off of the relationship between the debts of two different countries with the same duration.              

The Euro Bund/T-note Spread

For the last couple of decades, the Euro bund (10-year duration) and the US T-note (10-year duration) have been highly correlated. This is certainly a testament to just how connected the world economy is. Through booms, busts, and everything in between, the bund and the T-note have pretty much followed the same course and usually at the same time.

Euro Bunds T-notes Spread Monthly

Euro Bunds T-notes Spread Monthly

From 1999 through early 2013, the spread between Euro bunds and T-notes were stuck in a trading range where the bund would gain several full points against the T-note.  Then it would inevitably reverse and come all the way down to trade at a discount of a few points. Wash, rinse, and repeat.

 

An Outlier…Or a New Trend?

Things changed last year. The Euro bund/T-note spread cleared the price peaks of 2000 and 2005. The spread sold off into Labor Day of 2013, but it still managed to bottom above the 2005 top. For the last year the spread has continued to rocket higher into uncharted territory in the futures markets. In the cash market, the premium on 10-year notes reached a fifteen-year high of 1.45% over the bunds. As a matter of fact, the premium on the US 10-year notes hit a seven-year high against the 10-year Treasuries of their G-7 brethren.

So what gives? Although European and US Treasuries have both been trending higher over the last several months, it is the divergence between European and US monetary policy that has caused the European Treasuries to outpace the US Treasuries by such a wide margin.

About three months ago, the ECB introduced unprecedented monetary stimulus when they cut the deposit rate to minus 0.10%. This is the first time in history that a major central bank has employed a negative interest rate. On Thursday they unexpectedly cut rates again by another 10-basis points, putting the benchmark rate at 0.05% and the deposit rate at minus 0.20%. Even more stimulus could soon be on the way via some Fed-style asset purchases by the ECB. At the same time, the Fed is continuing to taper QE at every FOMC meeting. Yellen & Co. is verbally preparing the markets for an inevitable US rate hike in 2015.

Perhaps now is a good time to mention that famous quote by Keynes that “Markets can remain irrational longer than you can remain solvent”. One should not be lulled into a state of complacency when spreading the financial products of one country against another. When the historical boundaries are tested, there is no law that prevents them from a serious breach.

 

The End is Near!

OK, so the punctuation for the header should probably be changed from an exclamation point to a question mark. With the spread at multi-year highs in the cash market and all-time highs in the futures market, nobody really has a clue when or even if the trend will reverse. However, there are a few technical setups we can use to gauge a possible trend reversal. Historically, previous bearish trend reversals in the Euro bund/T-note spread have led to multi-year declines. The reward-to-risk ratio on such a trade could be quite lucrative. Here is what we are currently watching for:

Euro Bunds T-notes Spread Daily

Euro Bunds T-notes Spread Daily

On the daily time frame, the most active contract Euro bund/T-note spread has not made a close below the rising 40-day Moving Average since the first few trading days of 2014. Therefore, a close below the 40-day MA could be our first clue that the run is finally peaking out.

Another noticeable pattern on the daily time frame is that the soon-to-expire September contract Euro bund/T-note spread has not traded below a prior month’s low yet this year. The December contract becomes the most active contract this week, so we will focus on the August low of 21.51 for near-term price support. A break below a prior month’s low will alter this bullish price structure and alert us to a possible trend change.

On the weekly time frame, a bullish trend change was signaled last October when the nearest-futures Euro bund/T-note spread closed above the declining 15-bar Moving Average. The spread never looked back. An end-of-week close back below the weekly 15-bar MA would be a reversal signal.

 

Trade Strategy:

The blog will make a hypothetical trade by shorting one December Euro bund contract and simultaneously buying one December T-note contract if the spread makes an end-of-week close below the rising weekly 15-bar MA. Initially, the spread will be liquidated on a two-consecutive day close 10 ticks above the contract high that precedes the trend change signal.

Euro Bunds T-notes Spread Weekly

Euro Bunds T-notes Spread Weekly

Note: The risk is a bit trickier to determine on this spread because the Euro bund contract is denominated in Euros and the T-note contract is denominated in US dollars. A full point move in the bund is the equivalent of 1,000 Euros and a full point move in the T-note is the equivalent of $1,000. At the current exchange value of approximately 1.30, this means that the price fluctuations in the bund are about 30% greater in value than the price fluctuations in the T-note. A trader can equalize this by trading thirteen T-note contracts against ten Euro bund contracts. A ‘one-lot’ trader, however, needs to be very aware of how the exchange rate differential is impacting the P/L on the spread trade.

Will Interest Rate Spreads Peak? Our Interest Is Piqued!

Interest Rate Spreads

The interest rate markets have historically provided many good spread trading candidates. Potential trading opportunities could be shaping up in a few of them right now.  

Some interest rate spreads are based on the relationship between debts of different durations for the same country. (For instance, the long-term US 30-year bond against a medium-term US ten-year note). This is a traditional yield curve trade. 

T-bonds T-notes overlay monthly

T-bonds T-notes overlay monthly

The spread between 30-year bonds and 10-year notes are extremely correlated as they almost always move together in the same direction.  As a crude rule of thumb, one could state that the only difference between these two markets is that the 30-year bond moves about 40% faster than the 10-year note.

Other interest rate spreads are based on the relationship between the debts of different countries with the same duration. (For instance, the US ten-year note against the Canadian ten-year bond). This is an inter-market Treasury trade.

Let’s take a quick look at the first kind of spread.  

The T-bond/T-note Spread

The Fed’s QE program has kept a bid in the US bond market for the last few years. This has pushed the US Treasury market to historic highs and rates to rock-bottom lows. The Treasury spread has also been affected.

T-bonds T-notes spread monthly

T-bonds T-notes spread monthly

Historically, the T-bond/T-note spread has usually been a good candidate for a short sale whenever the T-bonds reached a premium of five points or more over the T-notes. No matter how high it went, the spread would ultimately reverse and erase the entire premium. Even in the depth of the financial crisis when the T-bond/T-note spread reached an all-time high of nearly fourteen points (premium T-bonds) at the end of 2008, it ultimately collapsed. The spread made it back to ‘even money’ (meaning that the prices of bonds and notes were the same) a little more than four months after the peak.

For the last three years, however, the T-bond/T-note spread has stayed far north of the ‘even money’ mark. After posting a new all-time high of just over eighteen points (premium T-bonds) in November of 2012, the one-year decline ended just below five points with the T-bonds still trading at a premium to T-notes.

On Thursday, August 28th the T-bond/T-note spread traded one-quarter of a point shy of last year’s peak, basis the nearest-futures. It has recovered about two-thirds of the entire drop from the November 2012 all-time high. Here’s the $64,000 question: Is this a manifestation of the ‘new normal’ that Bill Gross talked about or is this just a prolonged deviation from the mean that will eventually experience capitulation?

Regardless of the longer-term answer, it would seem that the T-bond/T-note spread is vulnerable to some sort of a reversal in the medium-term. There are two fundamental reasons for this. First, the Fed continues to unwind their QE bond buying program and the consensus is that a rate hike will come in 2015. Second, the government is projected to auction off $238 billion in Treasury supply in the second half of the year vs. the $133 billion that was auctioned off in the first half of the year. That’s a noticeable increase in supply.

Timing the reversal is the real issue, of course. We are not economists; we are traders. Therefore, we must be right and at the right time. In this business, being right early is still being wrong.

Looking at the daily and weekly time frames, there are three possible signals that one can use to identify a bearish trend change signal in the T-bond/T-note spread:

T-bonds T-notes spread daily

T-bonds T-notes spread daily

On the daily time frame, the dip in early July is the only time since the mid-November low was made that the most-active T-bond/T-note spread traded below a prior month’s low. It was a mere two and a half tick infraction, at that! Therefore, a close below a prior month’s low would alter this bullish price structure.

Also on the daily time frame, the pullbacks have been pretty uniform. Since the mid-November low was made the T-bond/T-note spread made several pullbacks of one to one and a half points from the peaks before it reverses and races to new highs. Therefore, any decline of two points or more from the high would signal an overbalancing of price and alert us to a trend change.

T-bonds T-notes spread weekly

T-bonds T-notes spread weekly

On the weekly time frame, a bullish trend change was signaled at the start of the year when the nearest-futures T-bond/T-note spread closed above the declining 20-bar Moving Average (by at least one-quarter of a point) for the first time since May 2013. The spread has continued to close above the weekly 20-bar MA every week since. Therefore, an end-of-week close below the weekly 20-bar MA (by at least one-quarter of a point) could signal a bearish trend change.

Trade Strategy:

The blog will make a hypothetical trade by shorting one December T-bond contract and simultaneously buying one December T-note contract if the nearest-futures spread makes an end-of-week close below the weekly 20-bar MA (by at least one-quarter of a point). Initially, the spread will be liquidated on a two-consecutive day close 8/32nds (one-quarter of a point) above the contract high that precedes the trend change signal.