Will grains follow metals?

June 19, 2006 09:39 AM

On a day-to-day basis, traders are best served by focusing on the ordinary while looking for indications for the extraordinary. When it comes to grains, this means you should trade with the seasonal bias while at the same time recognizing that on occasion, grains have both the potential and the historical tendency to create extraordinary trading profits. If you are interested in hitting the occasional second deck home run instead of just stroking singles, then an understanding of intermarket relationships in grains prices is essential.

Is 2006 one of those times to swing for the fences? The potential is there.

Sector analysis

Although fundamentals for the individual grain and oilseed markets — corn, wheat, oats, soybeans, soybean meal, soybean oil, canola and palm oil — vary so that different markets tend to lead the others at different stages, the grains also move together, to some extent.

Each individual market is impacted by a variety of fundamental factors including previous crop year carryovers and weather patterns. However, these relationships are not always the same. In one cycle, corn may exhibit superior price performance while another cycle may be led by wheat or soybeans.

Grains predominantly can be viewed as a sector instead of as a group of individual commodities. The focus then becomes the study of the broad intermarket forces that have in the past affected the sector as a whole.

Seasonal trends

The price trends for grains have a definite seasonal bias. Prices tend to bottom out near the end of the year at fall harvest time and then build higher after the “February break” through the spring as traders focus on the progress of the plantings for next season’s crops. Price tops typically occur between May and July.

But sometimes the seasonal trend can be swamped by a much larger intermarket trend, as occurred in the mid-1990s. Corn futures prices hit a bottom 1994’s end on schedule, but instead of topping out toward the middle of 1995, the price trend continued to rise all through 1995, before finally reaching a high in the normal time frame between May and July 1996.

Corn futures followed the broad seasonal pattern with a late-year low in 2005 before moving back up in early 2006 and may be on the way to another typical seasonal high in the May to July time frame. Generally that would be the time for buyers to either step aside or move to the short side of the market into the fourth quarter.

However, once corn futures have established a price peak during the May to July time frame, if this price peak is broken, as it was in 1995, larger and more powerful forces than seasonality are at work and a continued long bias is called for.

Grain prices trend with general commodity prices. Although an individual equity can rise in price even while the major stock market indexes are declining, the best time to be long equities is during a rising stock market. The same general principle is true for grains. For example, if you compare a chart of soybean futures with a chart of the Continuous Commodity Index (CCI) you will see similar price patterns.

Commodity markets rotate. Equity investors likely will be familiar with the concept of sector or group rotation. An equity bull market can start with one leadership group, and as the cycle progresses during economic expansion, money will gradually shift or rotate so that different sectors will take turns pushing the broad indexes higher.

A comparison of gold and wheat futures prices from 1984 through the end of 2005 illustrates this. Only a small number of rising price trends for wheat futures truly stand out on a chart. Of these the two best examples are the rising trend into the late 1988 highs and the bull market that ran through the mid-1990s.

The comparison makes the point that the common denominator for both of these bull markets in wheat was previous price strength in gold. Virtually the entire rally in wheat occurred after gold had moved close to a top. This suggests that, while grain prices will trend with broad commodity prices, bull grain market trends will occur at or near the end of similar trends in metals.

The relationship between corn futures and copper futures between the end of 1993 and the start of 1997 provides another example. Copper prices trended strongly higher through 1994 as corn prices declined. Then, once copper prices had moved near the cycle highs, money started to rotate out of the metals and into the grains. During much of the bull market run in corn prices into 1996, copper prices essentially traded sideways.

Interest rate markets are linked to commodity markets. Commodity prices tend to rise during periods of economic expansion. So, in general, a rising trend for commodities will go with a falling trend for bonds as interest rates move higher. This is especially true for copper.

“Showing some interest” compares the ratio of corn prices to copper prices with three-month Eurodollar futures. When Eurodollars are declining, it means U.S. 90-day interest rates are rising and vice versa. Corn tends to rise once copper peaks, which suggests the ratio of corn to copper will trend lower when copper is strong and then turn higher when the cycle rotates from the metals to the grains.

The chart shows the trend for the corn/copper ratio favors metals to grains while three-month Eurodollar futures are declining. So, copper prices will be stronger while short-term yields are rising; and once yields and copper top, grains should rise on both an absolute basis and relative to copper.

Current Situation

The trend for the CCI is still positive. This indicates the trend for grain prices is also positive, so traders should favor the long side. However, commodity markets have yet to rotate away from the metals

Similar to 1994, three-month Eurodollar futures prices have been trending lower as metals have outperformed grains. Grains have remained weaker relative to copper as the U.S. Federal Reserve has tightened credit conditions from the latter half of 2004 through the early part of 2006.

The seasonal trend suggesting grains tend to rise during the first half of the year provides a natural bias for grains so far in 2006. Grains also tend to move with the broad commodity trend, which remains bullish.

In addition, the larger and potentially more powerful intermarket relationships suggest that 2006 could be an extraordinary year if metals cool off.

To date it is too early to say whether the May correction in metals is a sign they have peaked. As long as metals appear to have upside potential, especially during a rising trend for U.S. short-term rates, seasonal tendencies will hold and you will have to wait until the wind is blowing out for your second-deck home run.

Kevin Klombies has traded futures since 1979. He is an analyst at www.TradingEducation.com and manager of a private investment partnership based in

Calgary, Canada.

About the Author