Seeds of an Opportunity
Although the Chicago wheat contract is the world benchmark for wheat prices, the Minneapolis and Kansas City wheat contracts normally trade at a premium to the CBOT wheat. This is because the Minneapolis hard red spring wheat and Kansas City hard red winter wheat are a higher protein content and, therefore, higher quality product that the CBOT soft red winter wheat. The Minneapolis and Kansas City wheat is what buyers purchase for food production.
As you would probably suspect, the price behavior of these three wheat contracts are highly correlated. However, there are times when one or two of the markets will outperform the other. This is where the spread opportunity lies.
In mid-August the nearest-futures Minneapolis wheat contract closed at a premium of more than $1-per-bushel to the Chicago (CBOT) wheat contract. That doesn’t happen very often. Historically, it appears to be ‘expensive’ whenever the Minneapolis wheat contract is at a premium of 70 cents over the CBOT wheat contract.
The problem with these old guidelines is that the spread has been substantially higher than 70 cents on a few occasions over the last several years. The Minneapolis/Chicago wheat spread made it to nearly two and a half dollars at the end of 2011 before finally rolling over. And the barn-buster, never-seen-before, all-time record high was made in 2008 when the spread finally put a flag on the moon and peaked at $8.53 (!) before crashing back to earth.
The interesting thing, however, is that the bear markets that followed in this spread all had the same outcome. Each time the Minneapolis wheat price reached a huge premium over Chicago wheat and finally ended the run, the reversal lasted until the price premium finally went to the Chicago wheat. Even the outlier bull markets of 2008 and 2011 couldn’t escape this repetition of history. Perhaps Mark Twain was correct when he said, “History doesn’t repeat, but it does rhyme.”
So the question is: Do we start looking for a reversal setup because the Minneapolis/CBOT wheat spread has surpassed the old watermark level of 70 cents…or do we wait for it to get somewhere in the vicinity of the 2011 level before stalking it?
The Ratio Filter
As readers of this blog already know, we like to use a ratio to filter what we see in the price spreads. This is done to normalize false readings of outliers that appear on a spread chart when the prices of the underlying markets are themselves at record extremes. Sometimes, the ratio can even be a tie breaker when deciding which spread to pursue as the trade opportunity with the highest probability of success.
Normally, the Minneapolis wheat contract will have a markup of roughly 10% over the CBOT wheat contract. At ‘normal’ levels, you can flip a coin to determine which way the spread will go. There’s not much of an edge at this level so we ignore it.
Our antennas go up when the Minneapolis wheat exceeds a premium of 25% over the CBOT wheat. This has happened about half a dozen times in the last four decades. It never lasted. As a matter of fact, the inevitable reversal that finally followed a reading above 1.25:1 drove the Minneapolis wheat all the way down to where it was priced at a discount to the CBOT wheat. This certainly indicates that a premium of 25% or more makes the Minneapolis/Chicago wheat spread a short sale candidate.
Last month the nearest-futures Minneapolis wheat/CBOT wheat ratio surpassed 1.25:1. Therefore, the ratio confirms what we already suspected with the spread: A short sale opportunity is shaping up here.
Dialing It In
Take a look at the December Minneapolis wheat/CBOT wheat spread. Although it’s been in an uptrend since the start of 2016, the price action of the last few weeks could indicate that the trend is changing.
First of all, the spread peaked at +82 1/4 cents on July 5th and had a normal correction. This price peak was briefly exceeded on August 22nd when the spread reached +84 1/2 cents and then quickly pulled back. This appeared to be a Wash & Rinse (failed breakout) sell signal.
Then it gets even more interesting. The December Minneapolis wheat/CBOT wheat spread made a new contract high of 89 cents on August 30th and then rolled over again the very next day. This one-day high close was enough to disqualify the first failed breakout attempt, only to turn into a second failed breakout attempt. It sure looks like the spread is having a hard time sticking at these levels.
Now direct your attention to the rising 75-day Moving Average. The spread has closed above the 75-day MA every single day for over six months straight. However, the spread has been on the defensive for the last three weeks and is now less than two cents away from support at the 75-day MA. Initially, a close below the 75-day MA for the first time since the first half of March and a break of the August 25th reaction low could be the technical catalyst that confirms the end of the bull run. If so, the short side of the December Minneapolis wheat/CBOT wheat spread seems like a good place to be positioned.
The blog is working a hypothetical order to sell one December Minneapolis wheat contract and simultaneously buy one December Chicago wheat contract on a close below the rising 75-day MA (currently at +71 cents). If filled, risk a two-day close of three cents above the contract high that precedes the entry (currently at +89 cents).