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#28 S2N: Is the Smart Money Smart?

#28 S2N: Is the Smart Money Smart?

micksonmatch
March 25, 2024

In today’s issue:

COT Report Smart Money
The 2-year yield leads the Fed Fund Rate

Today’s Spotlight

I don’t want to write a detailed history of the Commodity Futures Trading Commission (CFTC) Commitment of Traders (COT) report. If you want to learn about the rich history (starting in 1924) of this report, you can click here. Here is the basics you need to know:

Every Thursday, the report is released with quite some fanfare. There are many data vendors who charge a healthy sum for providing the data in chart format. I have gone directly to the source, taken the messy free data, and formatted it for our purposes. Essentially within the report is a breakdown as of Tuesday each week of what each trading segment holds in the futures market. The futures brokers are required by law to complete these reports, so there is a high degree of accuracy, although some positions can have a high degree of complexity, especially when there are hedged positions that a hedge fund can execute across multiple brokers.

For the sake of this note we will stick to the 3 main groups:

Commercial Hedgers (“Dumb Money”)
Small Traders (“Dumb Money”)
Large Speculators (“Smart Money”).

I like to keep things as simple as possible so I am working with the Net Leverage positions (blue line) of Large Speculators instead of showing the Gross Long and Short lines. My experience with this data is that there are so many slices and dices one can apply that they are just adding noise. We are focusing on the Large Speculators who are called the “Smart Money”. These are the hedge funds and managed accounts of speculative traders. The report also represents all futures and options positions in the futures market. Let’s dive into the chart.

The contract we are focusing on is the SP500 Future. The Net Leverage of Smart Money is short 0.4 million contracts. It is interesting to note that speculators are almost always short the SP500. From a long-term signal point of view, there is very little this chart is showing us now. We can see that the speculators have been getting more short over the last few weeks as the market continues on to new highs. We usually see extreme readings before any major turn happens.

For the sake of completeness, I will say a few words about Open Interest (green line). For every futures buyer, there needs to be a futures seller. Imagine you and your friends are trading cards. Every time someone promises to buy a card from another person at a future date, you write down a note of this promise. The total number of these notes (promises) that haven’t yet been fulfilled (because the future date hasn’t arrived yet) is like the open interest. If someone decides to cancel their promise, they need to find someone else to take their place, which would keep the number of open notes the same. If they fulfil the promise and exchange the card, then you remove the note, decreasing the open interest.

During the COVID crisis, you can see an explosion in open interest. The stock market went into free fall for a few days as the market digested the enormity of the pandemic. This drove the number of participants wanting to hedge or speculate on the market to extreme levels. The reading on its own, much like the net leverage position, isn’t as informative as monitoring the change over the previous few weeks. Extreme positions can be really good signal generators.

S2N Insights

The 2-year Treasury Yield is better than any Fed Chairman

Everyone thinks that the Fed Chairman and his or her Federal Open Market Committee (FOMC) call the shots. What most people don’t realise is that they actually just listen to what the market thinks. What makes it fun is that the market listens to what they think in this circular series of winks and nudges.

The blue line is the 2-year constant maturity Treasury yield, and the orange line is the Fed Fund Rates overnight rate.

To help make it clearer, from the long-dated chart where the Fed Fund rate was much more volatile in the 1980’s before Fed watching became a global sport, I have plotted a 5-year chart. You can see how the blue line has pretty much anticipated all future Fed Fund rate moves. The market is clearly calling for a drop in rates.