Arbitrage Idea on Food CommoditiesCME: Lean Hog ( CME:HE1! ), Live Cattle ( CME:LE1! )
Here is the official narrative on US inflation: The Federal Reserve’s monetary tightening policy has successfully brought down inflation rate from a four-decade high to about 3 percent, delivering much needed reliefs to US consumers.
Government data supports this narrative. Take food costs as an example: In August 2022, CPI on food items reached a record 11.4%, well above the peak headline CPI of 9.1%. Rising food costs were a leading inflation contributor. By April 2024, the headline CPI went down to 3.4%, while food CPI was even lower at 2.2%, according to the Bureau of Labor Statistics (BLS). Low food prices helped decelerate the overall inflation.
Grocery shoppers and restaurant diners would likely disagree as they tend to experience much bigger price hikes. Let’s read the same data from a different angle.
• The headline CPI (CPI-U) rose from 267.054 in April 2021 to 313.548 in April 2024. (Note: The BLS CPI data sets the years 1982-84 as a baseline at 100.) In other words, CPI-U has gone up 17.4% in the past three years.
• For the same period, food CPI rose from 273.090 to 321.566, up 17.8% in 3 years.
This data shows the whole picture. The cumulative effect of multi-year inflation has elevated prices to higher levels. Annualized rates of increase have indeed decelerated. But as long as they remain positive, price levels will continue to go up.
A Deep Dive on Food Inflation
The BLS categorizes food items into “Food at Home” and “Food away from Home”. This methodology would result in the same type of food showing up in two categories. The logic behind it is debatable. While it makes sense to observe and report sales prices from different venues, it makes the task of data analysis much more complicated.
I propose a reclassification of food items into meat, grain, and beverage categories. Each has several commodities trading on the futures market, where its price-discovery function helps bring all relevant supply and demand information together.
The Livestock/Meat Market
Live Cattle ( NASDAQ:LE ) and Lean Hog ( NYSE:HE ) are commodities contracts trading on the Chicago Mercantile Exchange (CME) futures market.
In the past five years, Live Cattle futures have gone up over 60%, well above the 27.4% in CPI-Food for the same period. Meanwhile, Lean Hog advanced less than 5%. Why beef price rose rapidly when pork price declined throughout most of the inflationary period? What’s reason behind the diverged price patterns between the two meat products? We will come back to this in the next section.
The Grain Market
Corn ( TSXV:ZC ), Soybean ( NASDAQ:ZS ) and Wheat ( SEED_MSTRWHYT_FUTURES_WASDE:ZW ) are commodities contracts trading on the Chicago Board of Trade (CBOT) futures market.
The 5-year price changes for Corn, Soybean and Wheat are 28.9%, 51.3% and 55.1% respectively, all above the 27.4% in CPI-Food for the same period.
We observed that grain prices peaked in 2022 after the Russia-Ukraine conflict started. Wheat prices doubled in a matter of weeks, as investors feared that production by the two major wheat exporters may be interrupted. More recently, grain prices were trending down in the past two years, a result of stable supply and weak global demand.
The Beverage Ingredient Market
The 5-year price changes for Cocoa, Coffee, Orange Juice, and Sugar are 252%, 196%, 63% and 29% respectively.
The spike of Cocoa price by 400% caught market attention earlier. This was followed by a nosedive with price cut in half. Cocoa contract does not have adequate liquidity. Trader speculation was likely the main factor causing the dramatic price movement.
Arbitrage Opportunity with Live Cattle and Lean Hog Futures
In “What Disinflation - Beef Price Went Up 64% in 5 Years”, published on August 7, 2023, I introduced an arbitrage idea for shorting (selling) the cattle-hog price spread.
The 20-year price chart shows that the spread between live cattle (LE) and lean hog (HE) broadly stays in the range of $20-$60 per 100 pounds.
On August 4th, LEV3 settled at $183.10 while HEV3 closed at $83.25. The spread has widened to nearly $100, well above the historical average.
On May 17th, Live Cattle August contract LEQ4 settled at $178.85, while Lean Hog August contract HEQ4 closed at $99.55. The spread has narrowed to $79.30, down $20.
Futures market confirmed my view. In my opinion, the same fundamental factors are still at work and could drive the spread down further to the $60 range.
1. Price Sensitivity and Substitution
o When beef price gets too high, its demands could be partially substituted by the lower-priced pork. Price sensitive consumers would choose pork chops over a steak dinner. The result would be lower beef price and higher pork price, as the demand for the former is redirected to the latter.
2. Mean Reversion
o The price spread at $100 was two standard deviations above its historical mean. Statistically speaking, such an outliner is abnormal. There is a good likelihood that the spread would fall back to the $20-$60 normal range.
3. Hog Cycle
o The multi-year Hog Production Cycle has major impact, with fewer sows yielding a smaller hog production in the next 12-18 months. Hog production reduction would result in higher pork prices down the supply chain.
For a thorough understanding of the fundamentals in the beef cattle and lean hog markets, please read my previous writings, listed at the end of this post.
To set up a short cattle-hog spread trade, one could sell one live cattle contract and simultaneously buy one lean hog contract.
Each cattle contract has a notional value of 40,000 pounds, or $71,540 (= $178.85 x 400). To buy or sell one contract requires a margin of $2,450.
Each hog contract has a notional value of 40,000 pounds, or $39,820 (= $99.55 x 400). To buy or sell one contract requires a margin of $1,500.
The two-legged spread trade requires an upfront margin of $3,950. Hypothetically, if the cattle-hog spread narrows to $60 from $79, the $19 difference would translate into an account credit of $7,600 (= 19 x 400). Using the margin as a cost base, the theoretical return on this trade would be 192% (= 7600 / 3950).
The trade would lose money if the price spread did not narrow.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
