Canada Markets

The Commodity Futures Trading Commission (CFTC) releases its latest data on market participants through the Commitments of Traders (COT) report every Friday afternoon. It contains a wealth of valuable information, helping to explain who was doing what, the impact their actions likely had on prices, and clues to what may lie ahead. The biggest problem is complexity. This will hopefully help you understand the report better and may well be beneficial to retain for reference.

It should be noted that the data is as of the close of trading on the preceding Tuesday, so any significant moves after that will not be reflected until the following weekly report.

The original format is referred to as the Legacy report while a far more detailed version has been provided since 2006 -- the Disaggregated report. Both are available for futures only or futures and options combined. Given the fact so many are incorporating options into their strategies, the latter is the more commonly followed. Finally, a Supplemental Commodity Index report covering futures and options combined is updated weekly.

I would like to start with the Commodity Index Trader (CIT) group found in the supplemental report given the potential for a repeat of their 2020-22 impact on ag markets. One look at the accompanying weekly corn chart with the CIT net-long position displayed and you know why.

CITs often have little lasting impact on prices (so receive little attention) but when they matter, they can really matter. The inflation surge to start the decade was a perfect example. By late 2019, those with significant wealth were increasingly worried about the Federal Reserve view that early inflation indications at the time were merely "Transitory." With inflation destroying real returns on investments, they began buying commodities as a hedge against inflation through CIT funds.

Futures markets provide an excellent form of leverage and liquidity for such a purpose, attracting their interest. As the chart shows, from the fall of 2019 to March of 2022, CITs went from 214,468 contracts net-long corn to 493,736 contracts. At 5,000 bushels each, they increased their ownership of corn by almost 1.4 billion bushels (bb) over that period. The price of corn was slow to react, given the bearish fundamentals at the time, but went from $3.09 per bushel (bu) in the spring of 2020 to $8.24 1/2/bu by April of 2022.

Then a bad thing happened for prices -- the U.S. Federal Reserve declared war on inflation, finally admitting it wasn't transitory. CITs quickly tried to liquidate their long hedges that had been so profitable and prices fell quickly to $5.62/bu by mid-July. Even though the war in Ukraine waged on with no end in sight. Their (CIT) long liquidation continued until they were back to 211,239 contracts net long by the end of December -- when it became clear that the Federal Funds target rate had topped out at 5.25-5.50%.

The critical point going forward will be whether inflation reaccelerates as it did in the 1970s and how the Federal Reserve deals with the signals. As signs have developed of such a scenario, the Fed continues to cut rates over concerns about the economy and labor market. With that, CITs have started to re-establish their long hedges -- currently at 323,959 contracts net-long corn. Given they are generally a leading indicator, more of the same could be expected if CPI and PPI continue coming in hotter than expected.

Corn was used for this demonstration, but the same story played out throughout the ag markets. Cattle markets were the exception as bullish fundamentals kept prices up in that case regardless of CIT long liquidation. Corn, Chicago wheat, Kansas wheat, soybeans, soybean meal, soybean oil, feeder cattle, live cattle and lean hogs combined had a CIT net-long position go from 812,206 contracts in 2019 to 1,398,356 by March 28, 2022, when the Fed declared war on inflation. Grain and oilseed prices have never recovered since.

Moving on, the Legacy reports are likely the most commonly quoted but my least favorite. They show the long, short and net positions of the Commercial group, the Noncommercial and the Nonreportable (small traders). Group titles are self-explanatory. As mentioned, futures only or futures and options combined versions are available with most consideration going to the latter.

The disaggregated report was introduced to provide better clarity using more classifications -- thus my preference. It breaks the commercial group down into "producer/merchant/processor/user" and "swap dealer." Swap dealers are often considered commercials in the Legacy report as they are hedging their risk using futures or options markets but clearly have different business interests than the ones dealing with the commodity. The producer/merchant/processor/user group tends to be managing risk by hedging with little need or desire to move markets, either on entry or exit. As a result, they are much more patient in liquidating positions than other groups -- money managers in particular.

The noncommercial group is replaced by "managed money" traders and "other reportables" while nonreportable (small) traders remain the same. Obviously the other reportables contain those large traders that don't fit into the other three categories.

Money managed funds tend to have the greatest impact on price movements. They have one purpose and one purpose only -- to profit from speculating in futures and options markets. They don't have a bias on price direction, only that the price is moving and that they are on the right side of it. They tend to be trend followers and momentum traders. They will add to a position aggressively if it is proving to be correct, thus adding to the momentum of a trend. That leaves them vulnerable to pushing prices beyond levels they would normally reach, either higher or lower. It is often the producer/merchant/processor/user group that is on the other side of the trade with no urgency to lift their hedges.

When money managed funds build up historically extreme position sizes, there is a risk of a liquidation event sending prices sharply against the trend. Given their only motive is profit, the faster they can get out the better during a correction -- often leading to violent liquidation first, decide if it was appropriate later type of reactions. The phrase "The trend is your friend until it ends" best sums up this group. The challenge is trying to foresee what might cause the "end."

One final thought on the topic. Without liquidity guaranteeing ease of entry and exit, futures markets die, and price discovery becomes much more difficult. They end up with the many delisted commodities like barley and flaxseed on the Winnipeg Commodity Exchange at the time. Hedgers also need speculators to assume the risk they are trying to limit. Going back to love them or hate them -- participants other than those directly involved with a commodity use futures markets for various purposes. I believe it's better to know as much as you can about the elephants you're dancing with -- they are all a necessary evil and the more we understand the better.

With that, keep in mind I'm always happy to get feedback along with any suggestions for future blogs.

Mitch Miller can be reached at mitchmiller.dtn@gmail.com

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