COT Report: A new regime emerges

Following an eventful week in financial markets, this week’s Commitments of Traders report shows quite a few significant changes. Firstly, net long positions in the euro and the British pound are no longer at bullish extremes. Secondly, open interest in most currencies and commodities (except the yen) has fallen substantially. Following intense volatility, traders are more hesitant to maintain large net positions. Crude oil remains at a bullish extreme, despite the fact that there are 41,845 fewer net long contracts this week.

The purpose of this weekly report is to track how the consensus is positioned across various currencies and commodities. When net long positions become crowded in either direction, we flag extended positioning as a risk. Crowded positions do not suggest an imminent reversal, but should be considered as a significant risk factor when investing in the same direction as the crowd. This is shown below:

CFTC COT speculator positions (futures & options combined) – February 13, 2018

Source: CFTC, MarketsNow

Notable extremes, significant changes in weekly positions, and large net positions as a proportion of open interest are highlighted above. Extremes in net positions are highlighted when speculator positioning is more than two standard deviations above trailing 1-year and 3-year averages. Weekly changes are highlighted when they are significant as a proportion of open interest. Finally, net positions as a proportion of outstanding interest are highlighted when they are large relative to historical averages.

The biggest changes in net positions this week includes falling net positions in the British pound, Canadian dollar and the Australian dollar. Net positions in GBP are sharply lower following concerns that Brexit negotiations remain contentious. Earlier this week, we wrote that comments from Michel Barnier are likely to dampen enthusiasm for pound sterling. Commodity currencies (such as AUD and CAD) have been relatively weak as concerns grow regarding the economic health of commodity exporting countries. Australia and Canada both suffer from very high consumer debt, reliance on commodity demand from emerging markets, and significant housing bubbles.

Emergence of volatility = a new regime

Prior to the sell-off earlier this month, risk-taking grew relentlessly as traders added to consensus net positions. Specifically, traders went long the euro, British pound and crude oil while going short the US dollar, Japanese yen and Swiss franc. In the background, volatility fell continuously, encouraging traders to increase the size of their bets (often using leverage). Now that volatility has increased sharply, a reversal is occurring. An overview of open interest in the euro is shown below for reference:

A 40%+ jump in open interest since 2017

Source: CFTC, MarketsNow

As can be seen above, open interest in euro futures and options rose from around 500,000 contracts at the outset of 2017 to around 720,000 contracts in late January 2018. Following last week’s sell-off, open interest has fallen sharply.

Despite volatility, risk sentiment remains positive

In general, net long positions in riskier assets are falling while safe haven assets (and the US dollar in particular) are gaining. While it is tempting to suggest that this is the beginning of a downturn, we remain bullish on the outlook for riskier assets and bearish on the US dollar. We remain particularly bullish on the outlook for the euro and gold, thanks to a strong rebound this week.

As we argued in a previous commentary on the US dollar, the current economic backdrop should result in continued US dollar weakness. Ex-US growth (particularly in the Eurozone) remains strong, while sentiment towards the US dollar is not at a bearish extreme. Markets also expect the ECB to tighten monetary policy later this year, limiting the effect of rate hikes in the US. Instead of a broad downturn, we argue that heightened volatility will result in a more moderate bull market for riskier assets going forward. As can be seen from this week’s data, traders are now hesitant to make big bets on consensus trades. As volatility emerges as a risk factor, global risk appetite should fall accordingly.