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Ignore feeder cattle futures?

Ignore feeder cattle futures?
Economist says the best course of action right now may be for cash markets to pretend feeder futures don't exist.


The best course of action for cattle cash markets may be to ignore feeder cattle futures, suggests Derrell Peel, Oklahoma State University extension livestock marketing specialist.

Peel's latest market comments came out Monday in his weekly email.

He said, "A growing chorus of cattle producers are expressing frustration regarding feeder cattle futures markets. For many years, I have defended the value of futures markets and the role of speculators in making those markets possible. However, it is increasingly important to ask and deal with questions and concerns, or the alternative may be undesired."

As feeder-cattle futures have become more tied to speculators and less tied to market fundamentals, one economist suggests the market might need to ignore them completely.

Peel noted that feeder futures have become increasingly volatile, often in ways that appear unrelated to market fundamentals. The resulting erratic movements of futures prices make it difficult or impossible for the industry to use feeder futures for its two primary roles of risk management and price discovery.

Liquidity needed

"Producers have historically been quick to blame speculators for unwarranted influence in cattle markets, but without speculators there would not be enough liquidity for most agriculturally-based futures markets," Peel said.

He noted since their inception in 1971, feeder-cattle futures contracts have had marginal levels of liquidity, which often limited their effectiveness. Feeder futures, and especially options, have been thinly traded in the distant contracts. This lack of liquidity makes it difficult for traders to have orders filled quickly, completely and cost effectively.

Peel said an important question is whether the changes in recent years aggravated the problem and if they threaten the future viability of feeder futures?

Institutional changes in trading hours and daily price limits are all pieces of the puzzle, he added. "Have trading hours become too long for the amount of traders taking positions each hour or even each minute, given modern technology?" Peel asked.

"Daily trading limits have been expanded to allow markets to adjust faster and not be hamstrung. While this is necessary in a world of generally increased commodity market volatility and higher-than-historical price levels, it also allows larger futures price movements when no fundamental reason exists or when a cooling off period is warranted."

Then Peel added that wider trading limits are not the cause of erratic futures market behavior, and focusing on trading limits may be ignoring the underlying cause of volatility.

"Outside" money

A growing proportion of the outside liquidity in feeder futures, meaning the money put into the markets by non-hedgers, is by many accounts from sources motivated primarily by portfolio management rather than actually speculating based on feeder cattle market fundamentals. Aided by computers and mechanical trading strategies, this type of activity tends to result in movements into and out of futures markets quickly and violently, Peel said. That results in greater market volatility as underlying liquidity is exhausted.

"Often this type of trading includes broad-based commodity indexes of energy, precious metals and other commodities and of which feeder futures is a tiny proportion," Peel said. "Yet, if or when large amounts of money is directed at these commodity indexes or directly into feeder futures markets, often for reasons unrelated to cattle markets, feeder futures go along for the ride.

"Unfortunately, erratic futures markets have a very real impact on actual cash feeder markets with consequences that impact the entire industry and not only for direct users or potential users of the futures market. Just talk to producers or sit at most any cattle auction; it’s obvious that participants are watching futures prices, both feeder and live cattle."

Peel said finding solutions for these problems is obviously a challenge. Futures markets cannot function without outside (speculative) liquidity. Yet he suggested it's becoming increasingly apparent that they cannot function effectively with high proportions of liquidity that has no ties to the basic commodity.

Peel said perceptions exist that feeder-cattle producers and feedlots are increasingly unwilling or unable to use feeder futures, meaning that speculative trading is responsible for more and larger price movements. This is having "significant detrimental impacts" on cash feeder cattle markets, he said.

"This suggests that feeder cattle futures could be on a path to imploding and completely collapsing," Peel said.

Having no feeder-cattle futures might be a lesser evil than the current situation and undue influence of speculation on the feeder-calf cash markets, he added.

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