Live Cattle/Lean Hog Spread
Despite the variation in fundamentals and the differences in the breeding cycles, the historical price trends between live cattle and hog prices are noticeably correlated. In broad strokes, this is likely due to similar feed costs, weather impact, and consumer demand.
With nearly half a century of price data showing the strong link between these two markets, we have assurance that the link is strong enough to trade one market against the other. You will notice that the hog prices seem to be a little more ‘spikey’ and that the cattle prices trend in a smoother manner. This is because the hog market has a shorter breeding cycle. Nonetheless, the hog market’s aberrations have proven to be temporary as it has always come back into synch with the cattle market.
Historical Spread Parameters
Live cattle usually trade at a premium over hogs. Either side of a 20-cent premium seems to be a somewhat normal level for the spread between the two markets.
Once in a while, we see brief occasions where the spread between live cattle and lean hogs widen to 35 cents or more. These are the times that spread traders need to sit up and take notice because an opportunity could be forming. Historically, premiums of 35 cents or more have been temporary events as the spread has inevitably returned to the 20-cents level.
After the historic drought of 2012 wreaked havoc in the grain and livestock markets, the live cattle/lean hog spread has gyrated all over the place. This year, it has surged to an all-time high. If history is any guide, this could be a nice short sale opportunity in the making.
Historical Ratio Parameters
With livestock prices at record highs, it is no surprise that the livestock spreads are also priced at historical levels. Therefore, it is prudent to take into account the ratio when trying to determine if a relationship between two different livestock markets are actually at an extreme. The ratio acts as a filter for the spread.
Forty-five years of history shows that the ratio between cattle and hogs has been volatile, but lacking in long-term trendiness or a change in the overall trajectory. For spread traders who are banking on a mean reversion, this is the perfect scenario.
Overall, it appears that the live cattle/lean hog ratio flip-flops violently over the 1.4:1 level. When the ratio drops below 1.1:1 (where cattle has a premium of less than 10% over the hogs) the cows are considered under-priced. This has been the right time to look for setups on the long side of the spread and go long cattle and short hogs.
On the flip side, a ratio of 1.8:1 or higher (where cattle has a premium 80% or greater over the hogs) has been historically unsustainable. These occurrences are where the prime short sale opportunities have occurred. Spreads traders empowered with the knowledge of history could have taken advantage of the situation by shorting the cattle and buying hogs. Ratios of 1.8:1 or higher have always been followed by substantial declines.
This year’s breakout to new all-time highs in the live cattle/lean hog spread has been confirmed by the ratio. The cattle/hog ratio joined an elite group this year as it reached 1.9:1 so far. The ratio has been this high on less than a dozen occasions in the last half century. Therefore, we should be looking for a trade setup on the short side of the spread.
Trend Change Signals
Based on the price action of the last week, there were two signals that indicated a possible bearish trend change in the February live cattle/lean hog spread:
First, the February live cattle/lean hog spread started the week with a break below a prior month’s low for the first time since the mid-July correction low was established. This altered the price structure. Furthermore, it occurred just a week after a new contract high was posted. This creates an ‘outside bar’ on the monthly bar charts since the spread has traded beyond both the previous month’s high and low.
Second, the February live cattle/lean hog spread closed below the rising 50-day Moving Average on December 8th for the first time since mid-July.
There is one thing that should make traders give pause: The ratio between the February live cattle and the February lean hog actually ended the week at a new contract high of 1.95:1! However, the February lean hog contract peaked out in July and sank to a new multi-month low on Friday while the February live cattle contract signaled a bearish trend change this week by way of a close below the rising 50-day Moving Average for the first time since August and a break below the prior two month’s lows for the first time this year.
The February live cattle/lean hog spread bounced off the December 8th nearly two-month low of 76.75 (premium cattle) and finished the week above the 50-day MA. Therefore, traders looking to short this spread might want to wait for a drop back under the December 8th low to increase the probabilities that the tide has finally turned.
For tracking purposes, the blog will make a hypothetical trade by selling one 40,000 lb. February live cattle contract and simultaneously buying one 40,000 lb. February lean hog contract if the spread closes below the December 8th low of 76.75. Initially, the spread will be liquidated on a two-consecutive day close of half a cent (50 pts.) above the contract high that precedes the entry (currently at 81.92).