Feeder Cattle/Corn Spread
As one would intuitively think, the market prices for feeder cattle and corn show a strong correlation. Corn is the feed that is predominantly used in the livestock business and feed prices represent the lion’s share of production costs.
When you look at the last four decades of history, it is apparent that major divergences between the price of feeders and corn are temporary events. When corn soars and feeders do not participate, the corn market eventually comes crashing back to earth as feed demand dwindles. When the bottom falls out of the corn market, strong feeder prices tend to usher in a recovery in the corn prices as livestock producers are banking fat profits and buying more and more feed for herd expansion.
Things can really get crazy when a drought occurs! The drought will send corn sky-rocketing as the crop gets wiped out. The soaring corn (feed) price causes the livestock producers to suffer financial loss, so they dump their animals on the market. This increases supply and exacerbates the price decline, widening the gap between the two markets even further. Once the dust settles (pun intended), the corn and feeder markets come back into alignment. When the corn prices settle down the livestock producers will start the breeding cycle all over. It takes time to raise the new animals so tight supplies will persist for a time and send livestock prices higher. This is exactly what has been happening since the US experienced the worst drought in several decades back in the summer of 2012.
No matter what the scenario, the point is that big divergences between feeder and corn prices have historically provided great opportunities to bet on a reversion to the mean.
The Feeder/Corn Ratio
At a quick glance, it appears that the normal ratio between a 50,000 lb. feeder cattle contract and a 5,000 bushel corn contract is somewhere around 3:1. It will often oscillate between 3.5:1 and 2.5:1. It is when the ratio trades outside this band that trading opportunities materialize.
Over the last four decades, there have been about half a dozen times when the ratio fell below 2:1. At this level, the feed prices were too expensive for livestock producers. This inevitably caused a significant change in the supply/demand of one or both of the markets. The ratio then reversed and went back up above 3:1. Take note: Whenever you see the feeder/corn ratio drop below 2:1, it’s time to start looking for a setup to get long feeders and short corn.
On the other side of the field, the feeder/corn ratio can be considered ‘extreme’ and unsustainable when it reaches 4.8:1 (nearly five-to-one) or higher. This has only happened a handful of times in nearly half a century of trading in the futures markets. Previously, ratios at such lofty heights ultimately experienced a plunge back down to 3:1 or lower.
Common sense indicates that a reversal off the high side is inevitable. At nearly 5:1, the profit margin is so huge that producers expand the herd as fast as they possibly can. And who can blame them? You gotta get it while the gettin’ is good. However, the ramped up production leads to overproduction, which leads to a supply glut and then softer prices. Hence, the cyclical ebb and flow of the feeder/corn ratio.
Historic High = Historic Opportunity
Last month the nearest-futures feeder/corn ratio reached a mind-boggling all-time high of nearly 7.5:1. At this level, livestock producers are snatching up feed for their animals for just a song and a dance. If you see a brand new Maserati pass you by on the streets this week, don’t be surprised if the driver is in the livestock business.
In late October, the nearest-futures feeder/corn ratio closed below the rising 50-day Moving Average for the first time in nearly half a year. This signaled a bearish trend change. For more than a year, closes above/below the 50-day MA have been accurate indicators of trend changes for the feeder/corn ratio. The implication is that feeder prices are about to break, corn is going to pop, or both.
The ratio has been in an uptrend since it bottomed out during the drought of 2012 and just last month it reached uncharted territory after a 2+ year run. In light of these facts, we think it is likely that the recent trend change signal marks not just “a top” for the ratio, but “the top” for the ratio. For their sakes, let’s hope that the Maserati-driving livestock crowd has their business costs hedged.
The Feeder/Corn Spread
The ratio between one April feeder cattle futures contract and one May corn futures contract peaked at 6.75:1 at the start of October and is currently trading near 5.9:1. To normalize the relationship between these two markets, we are going to look at the spread between the value of one 50,000 lb. April feeder cattle contract and the value of the sum of six 5,000 bushel corn contracts.
At the October 3rd contract high, the April feeder/May corn (x6) spread closed at +$13,025 (premium feeders). At the nearly two-month low on Halloween, the spread was valued at -$6,400 (premium corn). As in the case of the nearest-futures feeder/corn ratio, the nearest-futures feeder/corn (x6) spread also signaled a bearish trend change last month when it closed below the rising 50-day MA for the first time since the spring. Therefore, traders should be focusing on the short side of the trade.
The September/October push above ‘even money’ in the feeder/corn (x6) spread is a rare occurrence. This was only the second time in history that a feeder contract has been worth more than six corn contracts. Looking at more than four decades of history on the nearest-futures chart, we find that the spread between the value of one feeder contract and six corn contracts usually flip-flops somewhere around -$60k (premium corn). This is exciting news as is indicates that the spread is obscenely overvalued. Opportunity abounds!
Technical Resistance Levels
Based on history, a minimum downside objective for the feeder/corn (x6) spread should be -$60k (premium corn). Therefore, a trader’s objective is to find a spot somewhere long before then to get short. If you’re lucky, the spread will get a bounce to sell into. There are currently three critical resistance levels that traders should monitor.
An ideal minimum bounce would be to the Fibonacci .382 retracement of the current decline. This resistance level currently shows up at +$1,020 (premium feeders) for the April feeder/May corn (x6) spread. This is quickly followed by the declining 30-day Moving Average around +$1,368.75 (premium feeders). The 30-day MA provided support on the way up and offered an ideal buying level in August. Now that it has been broken, the 30-day MA should provide resistance.
Next, the Fibonacci .618 retracement of the current decline sets resistance at +$5,605 (premium feeders). In a volatile market, deep retracements to the Fibonacci .618 line can provide a fantastic location to enter on a reversal.
Finally, the October 3rd contract high of +$13,025 (premium feeders) is a make-or-break level. If the spread gets back up to the old high, traders should be looking for clues of a double top, a failed breakout, or a sustained breakout. The first two scenarios create a potential setup for a short sale, while the sustained breakout would indicate that you do not want to be caught holding the bag on the short side.
For tracking purposes, the blog will make two hypothetical trades in the April feeder/May corn (x6) spread. One trade is to get short on a bounce to the first Fibonacci resistance level and risk above the second Fibonacci resistance level. The other trade is to get short when the spread makes a new corrective low.
First, we will sell one 50,000 lb. April feeder cattle contract and simultaneously buy six 5,000 bushel corn contracts if the spread rallies to +$1,000 (premium feeders). Initially, this position will be liquidated on a two-consecutive day close above +$6,000 (premium feeders).
Second, we will sell one 50,000 lb. April feeder cattle contract and simultaneously buy six 5,000 bushel corn contracts if the spread closes below -$7,000 (premium corn). Initially, this position will be liquidated on a two-consecutive day close $500 above the highest closing price after October 31st that precedes the entry on this position.