Live Cattle/Lean Hog Spread
For the last couple of months, the IMC blog has been working a hypothetical order to initiate a short sale in the April live cattle/lean hog spread on a break below the December low of 73.65. April livestock contracts start going off the board this week, so this spread trade needs to be revised.
We now have our eye on the Christmas live cattle/lean hog spread. The summer spreads are trading at a steep discount to the April spread, but the December spread is priced nearly 14 cents ($5,600 on a single contract basis) above the summer spreads.
The December live cattle/lean hog spread peaked just below 84 cents (premium cattle) in October, December and January. It broke through this resistance barrier in March and peaked at a contract high of 89.625. Once the 84-cent resistance level was conquered, it turned into a floor of support.
Last week the December live cattle/lean hog spread made a two-day close back below 84 cents. This indicates that the breakout is over. Therefore, a short sale is warranted.
The ratio between the December live cattle and December hogs peaked at 2.45:1 on the first day of spring (March 20th). It has since dropped to 2.2:1. This is the biggest decline that the ratio has experienced in the last several months. It creates an overbalancing of price, which is indicative of a trend change.
Let’s get some perspective of what 2.2:1 means historically. In the last +40 years, the cattle/hog ratio has only been as high as 2:1 on five different occasions (including the current excursion). This is based on the weekly closing prices of the nearest-futures contract. The previous four occurrences were followed by declines to at least either side of 1:1. This took the ratio well below a more normal level of 1.4:1. In other words, it acted like a pendulum that swung from one extreme to the other. If that’s the case, it seems that the probabilities are favorable that the live cattle/lean hog spread is in for a multi-month or even a multi-year decline once the bull market finally ends.
Trade Reentry Strategy:
For tracking purposes, the blog will cancel the hypothetical trade to sell the April live cattle/lean hog spread. Place a new hypothetical order to sell one 40,000 lb. December live cattle contract and simultaneously buy one 40,000 lb. December lean hog contract if the spread rallies to 83.50 (premium cattle). Initially, the spread will be liquidated on a two-consecutive day close above 90.00.