NY futures were on the defensive this week, with December dropping 227 points to close at 76.45 cents.

We saw a familiar pattern this week, as renewed concerns about the economy prompted hedge funds to once again take some chips off the table. However, this time around the mood among traders is decidedly more negative than on previous occasions, since key support in the S&P 500 was violated and news on the economic front is rather worrisome, especially in the housing sector.

Even though very little current crop cotton remains for sale and we are going to end this season with the tightest ending stocks in many years, the July contract has not been able to rally past its 87.10 high of April 26 and December has yet to crack the psychological 80 cents barrier. In fact, December closed today just 24 points higher than where it was at the end of 2009 and only 85 points higher than where the spot month traded at that time. Why has the market made so little progress despite all the bullish factors that have come into play since then?

Probably the most logical explanation is that the ‘futures’ market has its name for a reason, because it functions as a discounting mechanism of expectations about the future. In other words, six months ago the market may have rallied in anticipation of the current tightness, thereby already discounting what has now turned into reality. Also, by acting as an early warning system, it has allowed market participants to take the necessary precautions to stay out of trouble. Mills made sure that they secured their needs early on, many of them by buying on-call. These buyers may have gotten a bit lucky in the end, since their fixations coincided with a period of heavy spec long liquidation, which has prevented a potential short squeeze.

Using the same logic, the market may currently be in the process of discounting what lies ahead several months from now. And what it is seeing is a promising US crop that has the potential to surpass the current USDA estimate by some 2 million bales, while the economic outlook for the remainder of the year is turning bleak. Therefore, we have a situation in which the trade would like to sell the market near 80 cents, but there is a lack of buyers on the other side. Until a couple of weeks ago speculators were rebuilding their net long position and provided the necessary liquidity to facilitate trades near 80 cents. However, with the stock market turning sour and economic numbers disappointing, they have since turned into net sellers, which means that there wasn’t any buying left near 80 cents. As a result the market has been falling in a vacuum in search of renewed support. It appears that the trade has finally stepped forward as a net buyer near 75/76 cents, as grower selling diminishes at these levels and mill fixation buying and merchant short-covering starts kicking in. Whether trade buying is sufficiently strong to stop additional spec selling remains to be seen and depends to a large degree on how outside markets behave over the coming weeks. Tomorrow’s unemployment report will probably set the tone in that regard.

Despite the current weakness we believe that the bulls still have a valid case as we head into the coming season. Inventories will be nearly depleted by the time new crop arrives and that is nowhere more evident than in the US and China. After another excellent US export sales report of over 400’000 running bales, unsold current crop supplies must be down to just a few hundred thousand bales if our calculations are correct. Total sales for the current season now amount to 13.7 million statistical bales, whereof 10.6 million have so far been exported. Commitments for the coming season currently stand at around 2.5 million statistical bales.

China, in a what looks to be a desperate attempt to curb runaway domestic prices, has agreed to release another 600’000 tons from its remaining Reserve, which is estimated at just 1.2 million tons. This would bring the total amount of Reserve auctions this season to around 3.2 million tons. Since the Chinese government will not feel comfortable to see its Strategic Reserves reduced to less than a month of domestic mill use, it is all but a foregone conclusion that China is going to replenish these stocks the next chance it gets. In other words, we expect the Chinese government to potentially extract up to 2 million tons from the local and/or international market next season, which should provide strong support on any dips that might occur.

So where do we go from here? With the release of the USDA planted acreage number this week, the market has started to focus on the potential size of the US crop. We expect next week’s USDA supply/demand report to show a crop of around 17.5 million bales, reflecting the bigger acreage and increased yield potential. Other crops around the globe should also show a slight net increase. If correct, then the promise of bigger production and uncertainty regarding the economy should keep spec buying at bay for now, which means that it will be up to the trade to support the market. However, since the trade is mainly buying on dips, we don’t see where the momentum should be coming from to bid the market substantially higher at this juncture. As mentioned last week, the market sees plenty of supply in the fourth and first quarter and any potential shortage is not going to show up until the second and third quarter of 2011. Although the market is a forward-looking mechanism, we doubt that it sees much more than six months ahead, with the exception of a few savvy traders perhaps. For this reason, we expect December to remain range-bound between 75 and 80 cents in the foreseeable future.

Best Regards