Gold vs. Black Gold?! It’s Worth Spreading.

The Yellow Metal vs. Black Gold

Believe it or not, there is a correlation between gold and crude oil prices.  Perhaps this is due to the fact that both respond to inflation/deflation in the same manner.  Heck, one could even say that crude prices are the cause of inflation/deflation.

By observing the plot of weekly closing prices over the last three decades, the correlation is easy to see from the macro view.  However, there are certainly periods where these two markets appear to be non-correlated or even inversely correlated.  This is to be expected since gold and oil have different fundamental drivers.  But history has shown that the non-correlated and inversely correlated periods have always been followed by reconciliation between the yellow metal and black gold as the correlation returned.

Non-correlated periods include 1985-1986 when the Saudis flooded the world with crude oil and caused the price collapse, a short period in 1990 after the invasion of Kuwait when gold peaked in the second half of August and oil shot higher until October, the first half of 2005 when gold was stuck in a trading range as oil rallied, and the first half of 2010 when oil was range-bound as gold continued to set new record highs.

Gold Crude Oil overlay weekly

Gold Crude Oil overlay weekly

Inversely correlated periods include 1993 when gold rallied throughout the year as oil kept dropping, 1996 when it was gold’s turn to drop all year as oil pushed higher, the first two-thirds of 1999 as gold dropped continuously and reached a multi-decade low while oil rocketed higher in the same period, the second half of 2000 as gold prices slumped and crude prices increased, the summer of 2003 when crude oil made a sharp correction as gold continued higher, the first four and a half months of 2004 where gold followed a downward trajectory as oil ran higher, during the great Financial Crisis when gold rallied from the October ‘08 low through February ‘09 as oil dropped and then as gold dropped from February ’09 through April ’09 while crude rallied, and April through September of 2013 when gold slipped lower as crude oil rallied for months.

After each of these periods of non-correlation and inverse correlation, the correlation between gold and crude oil returned.  Spread traders who recognized the changes in the relationship had ample opportunities for profits.

The Gold/Crude Ratio

If we’re going to spread the gold market against the crude oil market, it’s good to know where the relationship is at in comparison to where it has been historically.  To do that, we can look at the ratio between an ounce of gold and a barrel of crude oil.

Currently, the gold/crude ratio sits around 26:1.  This means that it would take twenty-six barrels of crude oil to equal the value of one ounce of gold.  Historically, the ratio has only hit 25:1 or higher half a dozen times in the last three decades.  Therefore, the current ratio of 26:1 is an outlier.

Gold Crude Oil ratio weekly

Gold Crude Oil ratio weekly

Furthermore, the current ratio is following an excursion to an all-time high of 42:1 that was hit about four months ago.  It appears that a capitulation high was established there and that the tide has turned.

When it finally reversed, the previous ratio readings of 25:1 or higher were followed by declines to 14:1 or lower.  Therefore, it is not unreasonable to expect the current decline to reach this level as well.

On the flip side, a spread trader should start watching for a buying opportunity when the ratio hits 10:1 or lower.  Who knows, perhaps we’ll get a chance to do so when the current bear market reaches its conclusion.  Like the old saying goes, “The bigger the bull, the bigger the bear”.  We just came off of the biggest bull market in the history of the ratio so the pendulum could swing to extremes the other way.

The Yellow & Black Spread

Now we’ll take a look at the spread between the value of a 100 oz. gold futures contract and the value of the sum of three 1,000 barrel crude oil contracts.  We are using three crude contracts to get close to equalizing the values of both sides of the spread.  Otherwise, the gold leg of the spread would have more than two and a half times the value of the crude leg of the spread.  This would mean that the changes in the gold market would be the dominating factor in the spread.

Normally, one gold contract is worth tens of thousands of dollars less than the sum of three crude oil contracts.  But this year the gold contract reach a record high of being worth as much as $35,590 more than the sum of three crude oil contracts.  It’s been nearly twenty-eight years since one gold contract has exceeded the value of three crude oil contracts, so this was a big deal.

Gold Crude Oil (x3) spread weekly

Gold Crude Oil (x3) spread weekly

Historically, the gold/crude (x3) spread is stretched thin whenever it has reached -$3k or less.  This means that gold came within three thousand dollars of matching the value of the sum of three crude oil contracts.  The spread has only made it near -$3k or higher on five occasions in the last thirty years.

Gold Crude Oil (x3) spread (1986 top) weekly

Gold Crude Oil (x3) spread (1986 top) weekly

The first time was in 1986 when the spread made it to +$2,120 (premium gold).  It then backed off to -$22,240 (premium crude) over the following year.

Gold Crude Oil (x3) spread (1988 top) weekly

Gold Crude Oil (x3) spread (1988 top) weekly

The second run-up peaked in late 1988 when the spread crested at +$3,080 (premium gold).  Eleven months later, it was priced at -$26,340 (premium crude) and a year after that the spread was at a record low of -$80,320 (premium crude).  This extreme price occurred because of Saddam’s Invasion of Kuwait, but it is still relevant.

Gold Crude Oil (x3) spread (1993 top) weekly

Gold Crude Oil (x3) spread (1993 top) weekly

The next time that the gold/crude (x3) spread peaked was in the last two weeks of 1993 when it posted a five-year high of at -$2,990 (premium crude).  Six months later, this spread was sitting -$22,970 (premium crude).  The bear market actually lasted about three years and didn’t establish a final bottom until it reached -$42,450 (premium crude) in January of 1997.

Gold Crude Oil (x3) spread (1998 top) weekly

Gold Crude Oil (x3) spread (1998 top) weekly

In December of 1998, the spread made it as high as -$3,290 (premium crude) before turning over.  Now, I know I wrote earlier that -$3k or higher was the line in the sand…but closing just $290 away from this price at a five-year high is certainly close enough!  Anyways, the spread crashed from there and sank to an eye-popping low of -$80,460 (premium crude) in just under two years’ time.  Interestingly, this undercut the 1990 Gulf War low by a mere $140 before turning around and ripping higher.  But the long side of the gold/crude spread is a discussion for another day.

That brings us to the current situation.  The gold/crude (x3) spread inverted –meaning that the gold contract had the premium over three oil contracts- in December 2015.  The spread posted a new record high in the first week of the year and finally topped out at +$35,590 (premium gold) when the second week of February started.  The premium went back to the crude oil side of the spread in mid-April and it has continued lower since.

Gold Crude Oil (x3) spread (2016 top) weekly

Gold Crude Oil (x3) spread (2016 top) weekly

If the current bear market stays intact, the spread could try to challenge price support at last summer’s low of -$61,960 (premium crude).  And if the ratio drops to 14:1 or lower like it has done in the past, the gold/crude (x3) spread would be priced somewhere between -$78,000 and -$148,000 (premium crude).  This puts a lot of profit potential on the table for spread traders.  Given the fact that the spread bottomed just below -$80,000 in 1990 and again in 2000, this would not be unprecedented.

Current Outlook

The December gold/crude (x3) spread peaked at +$14,850 (premium gold) on February 11th.  Since then, the spread has been in a downtrend, marked by lower lows and lower highs.  The bounces have been short sale opportunities.

After tagging technical support at the rising 75-day Moving Average in mid-March, the spread rallied $12,270 over a two-week period.  This made a Fibonacci 50% retracement of the initial decline.

The bounce faded and the spread made a two-day close below the rising 75-day MA in the first half of April for the first time since November.  This confirmed the trend change and sent the spread even lower over the following weeks.

Currently, the spread has rallied $17,940 in just over week.  This bounce took it to the Fibonacci .382 retracement of the entire decline to date.  Furthermore, the spread is just shy of the declining 75-day MA.  This particular moving average now serves as resistance because the spread is below it.

December Gold Crude Oil (x3) spread daily

December Gold Crude Oil (x3) spread daily

Another observation is that the December gold/crude (x3) spread has made lower monthly lows for four months in a row.  If the spread does not close above -$9,090 (premium crude) in the next two weeks, it will also mark four consecutive months of lower monthly highs as well.

In light of the current price pattern, the IMC blog is going to take its first crack at this spread by selling this rally into the resistance zone and risking a breakout above last month’s high.  If we get knocked out, we’ll quickly set new short sale parameters.  The train is confirmed to be south-bound, so now we need to find a way to hop on for the ride.

FYI, if this was a podcast instead of a blog, we’d cue Ozzy’s Crazy Train to start cranking right here…

Trade Strategy:

The blog will make a hypothetical trade by selling one 100 oz. December gold contract and simultaneously buying three December 1,000 barrel crude oil contracts at -$15,000 (premium crude).  Initially, the spread will be liquidated on a two-consecutive day close above -$9,000 (premium crude). 


Platinum/Gold Spread: The Outlier Grows


Last September the IMC blog entered an unleveraged position in the platinum/gold spread at the equivalent of -$201.20 (premium gold).  Leveraged was used on April 14th when the blog hypothetically bought another July-August platinum/gold spread at -$235.20 (premium gold).

The ‘add-on’ investment position was liquidated at -$291.60 (premium gold) on June 13th, resulting in a loss of -$5,640.

Platinum Gold spread daily (100-day MA)

Platinum Gold spread daily (100-day MA)

Furthermore, a speculative long position was also entered on the same date and at the same price. This speculative position will be liquidated on a two-day close below -$321.50 (premium gold), which could happen as early as today.

Reign of the Bear

The platinum/gold spread cracked the March 3rd record low today and the ratio of 0.75:1 is just shy of the January 20th multi-decade low of 0.74:1.  Failure to bottom right around here could escort the ratio to the October 1982 record low of 0.69:1.

Platinum Gold ratio (nearest-futures) weekly

Platinum Gold ratio (nearest-futures) weekly

Furthermore, the current one year and five-month inversion could soon match the one year and seven-month inversion that occurred from September 1981 and April 1983.

Obviously, the situation in the relationship between platinum and gold is an outlier.  At some point, it will end and a huge reversion to the mean will begin. 

Platinum Gold spread daily (inversion line)

Platinum Gold spread daily (inversion line)

But timing is everything…especially when leveraged futures contracts are involved!  This is why you need to manage your risk and position size correctly.  Once the bull market is in play, it will make sense to go for the gusto and pyramid positions.  Until then, concentrate on defense.  You do that by using stops and keeping low/no leverage.

Investment Strategy:

For tracking purposes, the blog will liquidate the long July-August platinum/gold spread investment position and simultaneously enter a long investment position in the October-December platinum/gold spread at the market-on-close on Friday, June 17th.  There are currently no liquidation parameters for this low-leverage position.  Factoring in the results of the recent ‘add-on’ investment position, the bankroll for this spread is now $101,920.

Speculative Strategy:

On the long July-August platinum/gold spread entered at -$235.20 (premium gold) on April 14th, roll to the October-December platinum/gold spread at the market-on-close on Friday, June 17th if the liquidation parameters are not triggered.  Risk the October-December spread to a two-day close below -$322.00.



US Treasuries: On the Sidelines

Gone Flat

The IMC blog initiated a short position in the September T-note/5-Year note spread at the equivalent of 9-12.5 on March 1st.  The spread was liquidated at 10-12.5 on June 13th.  This trade resulted in a loss of -$1,000.

T-note 5-year note spread daily (nearest-futures)

T-note 5-year note spread daily (nearest-futures)

On the nearest-futures chart, the T-note/5-Year note spread is less than one-quarter of a point shy of matching the multi-year high that was posted in February.  However, the September spread has closed well above it for the last four days in a row.  This puts it within striking distance of the 2012 top at 11-02.5.

Low Yield Contagion

The US interest rate spreads have continued to surge on safe-haven buying and ideas that the Fed will put off any further rate hikes in the near-term.  US economic data is not living up to expectations.

Furthermore, negative yields around the globe are spreading like a contagion.  Worries about next week’s Brexit vote have caused the 10-year Euro bund to hit a negative yield for the first time ever and the Swiss 30-year bond even went negative.

Seriously, who wants to lock in a negative rate –meaning that you are paying the government to borrow from you- for three decades?!  This is insane.

This is going on in Japan, too.  Their 10-year yield dropped to a new record in negative territory.

One of these days, people are going to pause and think about what they’re really buying when they purchase treasuries with negative interest rates.  When common sense starts trickling in, treasuries could experience a complete meltdown.  Therefore, spread traders should continue to monitor interest rate spreads for short sale opportunities.

Copper(x2)/Gold Spread: New Multi-Year Lows. What’s the Plan?

Nice Try

The blog entered a long position in the December copper(x2)/gold spread -$18,000 on May 26th.  The position was then liquidated on June 10th at -$25,915 for a loss of -$7,915.

We took a shot at the trade because the spread exhibited the same pattern that occurred at prior major bottoms.  Although it didn’t work out this time around, we still bet with the odds and defined our risk.  Regardless of the outcome, that’s proper trading.

Despite taking a hit on the spread, it is still a candidate for a trade on the long side.

Extreme Lows

The nearest-futures copper(x2)/gold spread breached the -$26k level today.  From here, it wouldn’t take much for it to go ahead and tag major price support at the 2009 all-time low of -$29,380 (premium gold).

Copper (x2) Gold spread (nearest-futures) daily

Copper (x2) Gold spread (nearest-futures) daily

Furthermore, the spread inversion has now lasted for seven months.  It hasn’t stayed under water this long since the 1980s.

Oh, and did I mention that the ratio between the value of one 25,000 lb. copper contract and one 100 oz. gold contract also shrank to a new multi-year low of 0.399:1?  That’s right on the doorstep of the financial crisis low of 0.35:1.

Copper Gold ratio (nearest-futures) weekly

Copper Gold ratio (nearest-futures) weekly

The copper/gold ratio has only been at 0.35:1 or lower on three occasions in the last four decades.  If it sinks into this area again, we may adapt by spreading three copper contracts against one gold contract in order to normalize the position.  And boy, do we hope that happens!  Short-term, when a commodity spread plunges to multi-decade lows it seems like a curse.  Long-term, however, it is recognized as a gift bestowed on traders from the market gods.  Keep a long-term perspective.

What’s It Mean?

It’s crazy to think that the copper(x2)/gold spread is priced almost as bad as it was during the depths of the financial crisis, huh?  The continued under-performance of an industrial metal like copper against a safe-have precious metal like gold is certainly ominous.  Perhaps we should have started the post with “It was a dark and stormy night…

Perhaps this is telling us that the global economy is a lot worse off than the stock market or the Central Banks and economists are letting on…

Perhaps the return of George Soros and his bearish macro wagers is the confirmation…

Perhaps China –the world’s largest copper consumer- is on the edge and about to be pushed off…

However it plays out, the beacon that the IMC blog will continue to follow is price.  If things really are going to hell in a hand basket then we shouldn’t get too many buy signals in the continued bear market.  After all, the December copper(x2)/gold spread has closed below the declining 100-day Moving Average for an entire year straight.

Copper (x2) Gold spread daily (100-day MA)

Copper (x2) Gold spread daily (100-day MA)

But what if this is a capitulation low and a major bottom is being established right now?  We believe that a trend change signal will get us on the long side of the buying opportunity of a lifetime long before it makes any fundamental sense to do so.

Trade Strategy:

Work a hypothetical order to buy two December copper contracts and simultaneously sell one December gold contract on a two-day close above the 100-day MA (currently at -$15,862.50).  Initially, the spread should be liquidated on a two-consecutive day close $500 below the contract low that precedes the entry.

Soybean/Cotton Spread: When Will It Unravel?

Playin’ It Loose

We’re going to take a look at a spread that has a sloppier correlation than most: the soybean/cotton spread.  The reason for the lower price correlation in this spread is obvious since there isn’t exactly a strong bond between the fundamental demand factors.  After all, you can’t exactly substitute soybeans for cotton or vice versa.  When was the last time you went to Gap and bought some jeans and T-shirts made out of soybeans?  Or ordered a cotton milk latte at the local coffee shop?

However, there are some commonalities between these two crops.  The growing season is the first thing that comes to mind.  Both soybeans and cotton crops in the US are planted in late spring/early summer and harvested in the autumn.  The specific dates will differ, depending on the weather conditions and which state the crop is grown in.

Another commonality is where the two crops are grown.  Many of the same states have land that can accommodate both soybean and cotton crops.  Because of this, you can get a lot of crop rotation where farmers will switch from raising one crop to the other.  This usually depends on the price differences between the two crops.

Since the crop years and locations are similar, it also means that the weather patterns can have a similar impact on both crops.  A good planting season that leads into ideal summer growing weather, followed by agreeable harvest conditions can mean bumper crops in both beans and cotton.  Conversely, a US drought in June or July can simultaneously wipe out both crops.

Soybeans & Cotton = A Volatile Relationship

When you compare the price charts of how these two markets have interacted over the last four decades, it appears that the relationship between the two has been as tumultuous as Rihanna & Chris Brown; sometimes the two run together, sometimes they seem to repel each other.  At the end of the day, though, they always seem to get synced back up.

Soybean Cotton overlay weekly

Soybean Cotton overlay weekly

This lower correlation means that the spread between the soybeans and cotton is more likely to experience outliers than something with a stronger correlation like crude and gasoline, gold and silver, feeders and live cattle, etc.  However, we still like to play it the same way.  First, we look for the soybean/cotton spread to reach levels that it rarely gets to.  Then we look for a change in the price action to tell us when to get involved and enter a position.

Historic Spread Levels

To examine the spread relationship between soybeans and cotton in the futures markets, we don’t just compare the prices of the two markets.  Instead, we look at the difference between the values of the 5,000 bushel soybean contract and the 50,000 lbs. cotton contract.

soybean cotton spread weekly

soybean cotton spread weekly

Looking at 45 years of price history (basis the nearest-futures weekly closing prices), it appears that the spread is expensive whenever a soybean contract is worth $20,000 or more than a cotton contract.  Conversely, the spread is historically cheap whenever a cotton contract is worth $10,000 or more than a soybean contract.  It may take months or it may take years, but whenever the soybean/cotton spread hits or surpasses either one of these levels it has ultimately reversed and gone back to even money where the two contracts have the same value.

Normalize It

Given the fact that the ag and grain markets have had some huge moves in the past and the fact that soybeans are priced at levels that were unheard of until less than a decade ago, it is possible that the spread relationship between beans and cotton can be unrealistically skewed.  The ratio can help us determine if this is the case or not.

soybean cotton ratio weekly

soybean cotton ratio weekly

Using the same 45 years of price history, we can get the bird’s eye view of the soybean/cotton ratio.  By our account, the ratio is expensive whenever it reaches 1.8:1 or higher (where a soybean contract is worth at least 80% more than a cotton contract) and it is cheap whenever it sinks to 0.66:1 or lower (where a cotton contract is worth at least 50% more than a soybean contract).

Armed with both the spread and ratio parameters, we can now look at the current situation to see if a trading opportunity is materializing.

Where It Stands

This year started out with the new crop spread between November soybeans and December cotton priced either side of +$12k (premium beans).  This was certainly nothing to raise eyebrows.  However, the spread started trending higher from the early January lows and hit the +$20k threshold in early May.

Here we are a month later and the spread is accelerating.  Today it closed at a new contract high of +$24,532.  This is a strong bull run.

Nov-Dec 2016 soybean cotton spread daily

Nov-Dec 2016 soybean cotton spread daily

The Nov-Dec bean/cotton ratio hasn’t quite reached the historical expensive marker of 1.8:1 yet, but it’s getting close.  So far, the ratio has reached 1.76:1.  It wouldn’t take much to ring the bell at 1.8:1 sometime soon.

The bull run in this spread has been supported by the rising 30-day Moving Average.  The Nov-Dec bean/cotton spread has closed above the 30-day MA every single day for five consecutive months.  In addition, the pullback in early April and the correction into late May both stopped near the 30-day MA.  Therefore, the IMC blog will use a two-day close below the 30-day MA for the first time since the first week of 2016 as a green light to take a shot at the short side of the spread.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 5,000 bushel November soybean contract and simultaneously buying one 50,000 lbs. December cotton contract on a close below the rising 30-day Moving Average (currently around +$21,332).  Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry (currently +$24,532).

US Treasuries: One Out and One Down

Knocked Out

The IMC blog initiated short positions in the US yield curve at the beginning of March.  Thanks to the weaker-than-expected jobs report last week, one of the liquidation parameters were elected.

A short September T-bond/T-note spread was entered at the equivalent 31-14 on March 1st and liquidated at 35-20 on June 3rd.  This resulted in a loss of -$4,187.50 per spread.

Also, a short September T-note/5-Year note spread was entered at the equivalent 9-12.5 on March 1st.  The exit criterion is to bail on a two-consecutive day close above 10-06.  This hasn’t happened yet, but it’s gotten awfully close.  The spread hit 10-05 just last week!

Stretched Thin

Despite the fact that the T-bond/T-note spread was liquidated, it remains on our radar screen for another potential short sale.  The September spread posted a new contract high and is now just a tick away from the 36-00 mark.  This puts it right on the doorstep of the 2015 top at 36-14 and the February 2016 peak at 36-10.

T-bond T-note spread daily (nearest-futures)

T-bond T-note spread daily (nearest-futures)

However, the nearest-futures spread hit a new high of 37-12 today.  This is a bullish event for the spread.  Because of this potential breakout, we’re going to hang back a bit and see if the breakout is sustainable or not before we post any reentry parameters.  A two-day close back under the February high of 35-11 in the September spread could do the trick.  If something interesting develops, we’ll certainly have more to say.