By Jason Pearce
Has the Wheat Crop Flip-Flop Stopped?
About a month ago, we posted a watch list of various inter-market spreads that offered trading opportunities. It was based on the criteria that the spreads between several correlated markets had reached price boundaries that were historically extreme. Some of the spreads had already rolled over and were fair game; some were still trending in outlier territory and should be closely monitored. All of them had a history of making sizable reversals.
In the grain sector, the relationship between Kansas City and Chicago wheat caught our attention. The price of the KC wheat dropped below the price of Chicago wheat back in late June. This set things in motion for a buying opportunity. You know the old disclaimer that’s going to be inserted right here: Past Performance Is Not a Guarantee of Future Results. However, good trading is about probabilities, not prediction. Therefore, I would submit to you that Past Performance Can Tell You Something About the Probabilities of the Future.
History shows that anytime the price spread between Kansas City wheat and Chicago wheat inverted it has always been followed by a recovery. So we’ve been keeping an eye on this spread since the inversion. Recent price action suggests that a recovery from the summer price flip-flop could finally be underway. This may be the green light we needed for spread traders to get positioned on the long side.
Paying For Quality
The price difference between the wheat contracts in Kansas City and Chicago is not due to the location of the exchanges, it is based on the differences in the types of wheat for the underlying futures contracts. The Kansas City wheat contract is for hard red winter wheat and the Chicago wheat contract is for soft red winter wheat. The protein content of hard wheat is higher than that of the soft wheat. It is considered to be of a higher quality, so it normally trades at a higher price.
Although we are looking at two different types of wheat here, the price correlation between these two crops is extremely high. When you superimpose the price charts of Kansas City over the Chicago wheat, you’d be hard-pressed to spot the difference between the two. This high correlation between the two markets makes for a ‘safer’ spread trading candidate. ‘Safer’ is a relative term, though. When you are dealing with leveraged futures contracts, there’s always risk involved. But risk management and strong correlations in spread relationships help to mitigate the risks.
Despite the higher quality, the price premium of the Kansas City wheat over the Chicago wheat is not a locked in guarantee. This is because there can occasionally be changes in the supply and/or demand of one of the crops that does not impact the other crop as much. So one of the contracts may rise or fall faster than the other. This has been the case for this year.
The Inversion of 2015
Ample supplies around the globe and multi-year highs in the US dollar have weighed heavily on the entire wheat market this year. This was merely a continuation of the multi-year bear market across the entire grain sector. However, there was a temporary run-up this summer when the soft wheat growing region was hammered by a deluge of rain. This occurred just before right before the harvest as the seeded area was already below the five-year average.
The price decline continued when the second half of the year started and Kansas City wheat moved down at a faster rate than the Chicago wheat. Ergo, the spread price inversion. The government resumed their projections for global grain supplies to reach new all-time highs before the next North American harvest. This week’s new multi-year high in the US dollar only serves to reinforce the bearish outlook.
Despite all the gloomy news about abundant grain stocks and the strong greenback, the wheat market may be vulnerable to a rally right now. According to the recent weekly Commitments of Traders report, speculators have increased the size of their net short position in the Kansas City wheat rose for six consecutive weeks. This is the longest such bearish streak in four years. Furthermore, the size of the net short position is the largest in nearly a decade.
These short positions are speculators that we are talking about. They don’t actually have the physical wheat to deliver against the contracts that were sold short. Should any of the CTAs or hedge funds decide to do some short-covering as we approach year end, it could result in a sharp rally that triggers program-buying (buy stop orders) by other speculators. This may have a domino-effect and continue pushing prices higher as more and more buy orders are triggered by higher prices. The KC/Chicago wheat spread would likely soar on the turnaround. Any bullish change in the underlying fundamental picture would only add fuel to the fire.
Know the Boundaries
Just like in healthy human relationships, it’s important to know where the boundaries are at in spread relationships. When boundaries are tested or crossed, the balance of things will be upset. Something big will happen. In spreads, this usually means that a reversal is inevitable.
At normal levels, Kansas City wheat should have a price premium either side of 10% over Chicago wheat. When that premium climbs to 20% or more, then it’s time to pay attention. The KC wheat has only reached a premium of 20% or more over the CBOT wheat about half a dozen times in the last four decades and it never lasted. Therefore, if you even see a +20% markup on the KC wheat you know that the KC/Chicago wheat spread is a prime candidate for a short sale.
Conversely, when the Kansas City wheat loses its premium over the Chicago wheat it’s a warning shot for traders. In the event that the Chicago wheat reaches a premium of 5% or more over the Kansas City wheat, it’s time to get your game plan (and your capital) together for an opportunity on the long side of the spread.
For Chicago wheat to surpass a 5% premium over Kansas City wheat, the KC/Chicago wheat ratio has to drop to 0.95:1. The ratio has only been this low two times in the last ten years and not even a dozen times in the last four decades. The inversion was always temporary. Inevitably, things would play out and Kansas City wheat would go back to have the normal 10% premium (or more) over Chicago wheat. In spread terms, KC wheat would get back up to a 35 to 40 cent premium over Chicago wheat.
Darkest Before the Dawn
In late June, the nearest-futures KC wheat closed below the price of the CBOT wheat. This was the first spread price inversion in three years so we immediately put it on the watch list. The spread rebounded in the second half of July, but it was never able to get back above the ‘even money’ mark. It just settled into a trading range for the rest of the summer.
A month ago, the nearest-futures December KC/CBOT wheat spread left the trading range and plunged to a new eight-year low of -40 1/4 cents (premium Chicago) on the daily timeframe and -33 cents (premium Chicago) on the weekly timeframe. The spread has only been this upside down on three other occasions since 1970. This is a big deal. The more infrequent that the price levels have been hit, the more potential the spread has for a major move. By all accounts, there was nothing to stop the KC/CBOT wheat spread from sinking to the September 2007 capitulation low of -61 1/2 cents (premium Chicago). The relationship was coming under fire.
Turning On a Dime
Despite the new multi-year lows in early November, the spread has since made quite a turnaround. More impressively, this occurred in the face of new contract lows in both the Kansas City wheat and the Chicago wheat just this week. It is quite possible that the spread has finally bottomed out.
Further evidence of a turnaround is the behavior of the spread itself. First of all, the March KC/Chicago wheat spread ended the month with a close above the declining 75-day Moving Average for the first time in six months.
In addition, the spread has rallied nearly 25-cents from the November 5th contract low. This is the biggest rally in fourteen months. It is also the longest rally since the bounce off the December 2014 low. This ‘overbalancing of price and time’ is indicative of a trend change. Based on history, the KC/Chicago wheat spread may now be on its way toward +40 to +50 cents (premium Kansas City).
Outside Confirmation (Just In Case You Need It)
Coincidentally, Societe Generale is on the same page as us. Although they recently lowered their average price forecasts for several ag markets, the bank actually raised their price expectations for soft red winter wheat. Moreover, they stated that they expect the Kansas City wheat to go back to trading at a premium of 7-10% over the Chicago wheat in the first quarter of 2016. Perhaps the analysts are students of history. Perhaps they read our research.
What to Do Now
It’s time to get long. Simply put, spread traders should be buying Kansas City wheat contracts and shorting the Chicago wheat contracts.
For entry points, you might want to consider buying a pullback of 8-10 cents. This idea is based on the current price structure: During the multi-month decline off the May top, the March KC/Chicago wheat spread made several bounces of ten cents or more. During the recent one-month rally, the spread has made a pullback of six and a half cents and another pullback of nine cents. Therefore, countertrend moves of 8-10 cents appear to be good entry opportunities.
Seasonally, the KC/Chicago wheat spread has a tendency to soften in the second half of December. Buyers can use this to their advantage by scaling into a position if the pullback materializes.
The November 5th contract low of -26 cents (premium Chicago) is an important line in the sand for the March KC/Chicago wheat spread. A close below this price would indicate that the recovery is in jeopardy. Therefore, it would be prudent to use such an event as a liquidation signal for long positions. Take the hit, get to the sidelines, and wait for a recovery signal before you reenter.
Even if the KC/Chicago wheat spread plunges to new lows before the year is out, it should eventually rebound. Unfortunately, we don’t have a crystal ball that tells us how low it will go first before that happens. Every record low price in history was made when the previous record low was broken. You don’t want to be held hostage in a long position during those sorts of events. Cut your losses if the spread between the hard red wheat and the soft red wheat dips into the red. You can make it all back once it’s in the black.
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