Data Interpretation Problems

Oddly enough, these days it has become more difficult to interpret positioning data. We get more granular data than before, such as e.g. the disaggregated commitments of traders reports (CoT – even if they are still released with a three day delay), but at the same time the goal posts in futures markets have shifted greatly. Former extremes in positioning have been left in the dust with the advent of QE (and the associated desperate “hunt for yield”) and the adoption of large scale systematic trading. Here is a glaring example illustrating the point:


Speculator net positions in crude oil futures: after decades in which net long positions rarely exceeded 100,000 contracts, a new post GFC era record has been set in the speculative position at 740,000 contracts net long in early February 2018.


Just because there is more money to go around, there is not more intelligence to guide it, to paraphrase Kenneth Galbraith (a man we otherwise disagree with on almost everything, but this quote is hitting the nail on the head). Then again, we also disagree with the often heard glib assertion that speculators represent the “dumb money”.

In fact, this is demonstrably untrue. For the most part they are simply trend followers and as such will be correct as long as a trend is in place. They are often grievously wrong near turning points, but not always (or rather, not all of them).

In fact, since the goal posts with respect to what represents an extreme position have shifted to such a great extent in the past decade (in many cases we have yet to establish where the new limits actually are), it is necessary to look for other signposts when trying to interpret the data.

Consider for instance that speculators are not a monolithic group. Some of them are presumably smarter than others, and that should be visible in the data.

That is indeed often the case. We have for example seen clear divergences between prices and the net speculative position at the peaks in crude oil in 2008 and gold and silver in 2011. In other words, a number of speculative longs quietly made their exit from these markets in the weeks before prices peaked.

In 2007 and 2008 speculators correctly concluded that despite official reassurances to the contrary, the housing bust was not “contained” and amassed a large net short position in stock index futures. It was the only occasion we know of when they actually managed to enter a large net short position before the market concerned tanked.

It should be noted to this that the 2007-2009 bust was the most glaringly obvious bust in post-war history – one really had to be a central banker or a mainstream economist to fail to see it coming (and even among the latter a handful did in fact correctly foresee it, as opposed to the usual zero).

If we zoom in on the WTIC chart shown above, we can actually see an example of speculators beginning to change their mind despite further price increases in the oil market. This is the type of divergence that is often a meaningful signal.


The speculative net long position in WTIC futures has begun to decrease noticeably even as prices have increased further. Crude oil futures remain in backwardation, which continues to support prices, but the forward curve is beginning to flatten.


Since crude oil is arguably the most important industrial commodity, this could be an early warning signal with respect to future economic growth. Of course the US yield curve is still flattening, which is to say boom conditions continue to prevail – but it is now getting close to inversion, and usually the boom turns to bust shortly thereafter.

Here is the 10 year minus 2 year yield spread as a proxy for the steepness of the yield curve:


Rapid flattening of the yield curve usually coincides with the final hurrah in the stock market and signals that the boom is nearing its end – but it is only when the trend changes to equally rapid widening that recessionary conditions are actually ante portas. The stock market can easily crack months before that happens – in fact, 1987 has illustrated that an overvalued stock market with structural deficiencies can suffer an outright crash even if no economic recession is in the offing.


The signal is given when the flattening/inversion move ends and gives way to rapid widening of the spread. Interestingly a few recent futures positioning data in interest rate instruments are hinting at this possibility as well – as we will show below.


A New Widow-Maker Trade in the Making?

First let us look at one of the most stunning positions in futures markets in terms of its sheer size, namely that in euro-dollar futures. Euro-dollars is the generic name for USD-denominated time deposits held abroad.

ED futures are a speculative/hedging vehicle on 3-month time deposit rates, with the 3 month LIBOR rate, i.e. the interest rate offered in the London interbank market for 3-month loans, used as a proxy for settlement purposes. A short position is therefore a bet on rising rates and vice versa.

Each ED contract refers to an underlying value of USD 1 million, so the recent record high in the net speculative short position of more than 4 million contracts represented a notional value of over USD 4 trillion – not exactly chicken feed. In the meantime this net short position has declined quite noticeably, despite the fact that 3-month LIBOR is just 5 basis points below its recent highs.


Another noteworthy divergence between prices and the net speculative position: speculators have covered more than 1 million contracts of their net short position in ED futures. It is worth noting that despite the Fed’s declared intention to continue hiking short term rates, 3 month LIBOR has not increased further since putting in a high at 2.37% in early May – in fact, the rate has declined by around 5 to 6 basis points since then.


Obviously, this may have implications for the Fed’s declared intention to hike US rates further as it indicates that the growth narrative may be fraying at the edges. The first disbelievers are definitely emerging, and usually these early birds turn out to be the “smart money”.

So what is this talk about a “widow-maker” trade about? The original widow-maker trade consisted of shorting JGBs in the expectation that the bull market in Japanese government bonds could not possibly continue. Occasionally there was in fact a playable short term downturn, but a real bear market never developed.

A myriad reasons were cited as to why shorting the market made sense: rates could not possibly go lower, price inflation would return at any moment, the Japanese government would become insolvent, and so forth. Assorted hedge funds and traders started shorting JGBs for one or more of these reasons more than 25 years ago already, but eventually all JGB shorts would end up being carried out feet first – hence the term widow-maker.


10-year JGBs since 1988 – there were a few downturns along the way, but a genuine bear market stubbornly failed to emerge.


Another type of divergence between positioning and prices which we believe is often meaningful is when speculators enter into very large net long or net short position without managing to move prices one iota. This has just happened in t-note futures to a never before seen extent. Yet another record net speculative short position was recently recorded in this market:


In the time period designated by the blue rectangle, speculators have boosted their net short position by more than 400,000 contracts to almost 700,000 contracts net – producing no net price movement whatsoever. This kind of exposure is highly likely to invite a spanking by the markets.


Apparently “everybody knows” that 10-year yields are headed higher (and t-note prices lower), but this may well turn out to be a case of “what everybody knows isn’t worth knowing”.


Another stunning new extreme in the speculative net short position in 10-year treasury note futures.


If the addition of so many new short positions without moving prices does indeed turn out to be a contrarian signal as we suspect, its message is the same as that we are getting from the divergences in speculative futures positioning and prices in ED and WTIC futures: the growth narrative is potentially under threat.

If the growth narrative is in trouble, all the newly minted recent gold shorts (note gold is already up $32 from its overnight low on August 15) will be in trouble as well – and the same goes for those long risk assets, primarily equities and corporate bonds with low investment grade or junk ratings.

Perhaps we are not too far away from returning to conversations such as these:


Future 10 year t-note related conversations…


Charts by: SentimenTrader, StockCharts, BarChart


Cartoons by: Hedgeye




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