NY futures rebounded this week, with December advancing 124 points to close at 74.71 cents.

It has not been easy for traders to make sense of the cotton market recently. Not only are there conflicting signals, but one also needs to constantly be aware of the crosscurrents in these volatile outside markets. While the general direction of the cotton market has been down since the middle of June, inversions and the lack of carry on the board have been contradicting this seemingly bearish trend.

The Oct/Dec (486 points) and even the Dec/March (60 points) inversions make some sense, since the certified stock has all but disappeared (75’782 bales as of this morning) and the pipeline won’t start to fill up again until new crop arrives in volume. But the lack of carry exists beyond that since there is just 168 points available for the four months between March and July 2011, despite expectations of a 19 million bales US crop. Even further into the future there is another inversion of 361 points between July 2011 and December 2011. So while the directional trend seems to be telling us that there will be plenty of cotton to pressure prices, the spreads behave like the opposite were true.

This dichotomy may have something to do with the fact that speculators and index funds were responsible for the market’s recent decline by selling 2.7 million bales net between June 22 and July 13. Since nearly all of their positions are in the December contract, which accounts for over 70 percent of open interest, they can influence the nearby contract but play a lesser role in the spreads, which is primarily the trade’s domain.

From what we can tell the trade is not bearish, at least not from current levels on down. We can’t remember a season when inventories were tighter and even though world production is expected to rise considerably in the coming season, it can barely catch up to consumption, which means that stock levels will probably remain tight. To see over a million bales of certified stock disappear since June 3rd and to be treated to these stellar export sales reports week after week is a clear sign that we are dealing with an unusual situation this season.

Last week the US sold another 382’000 running bales of Upland and Pima, of which 92’700 running bales were for prompt shipment. This brings total commitments for this season to 14.1 million statistical bales, of which 11.5 million bales have so far been exported. The 2.6 million bales in outstanding sales for the current marketing year, which has just 16 days to go, is about a million bales higher than last season. We therefore estimate that around 1.8 million will get carried over into the coming season, where they will be added to the 3.3 million statistical bales that have already been sold for 2010/11.

In other words, we will start the coming season with at least 5.1 million bales of commitments on the books, plus whatever will be sold until the end of this month. The number will probably be closer to 5.7 million bales by August 1. Since only 2.9 million bales will be left in inventory at the end of July according to the USDA, we will start the new season roughly 2.8 million bales “short”, meaning that the bales needed to meet these existing commitments have yet to be produced. This number is likely to grow quite a bit bigger in August and September before harvest gains momentum. Again, the current situation is quite unusual, because beginning stocks typically more than cover existing commitments at the beginning of the new marketing year. Take last year for example, when we started the season with 6.34 million bales in inventory, while commitments amounted to less than half of that.

It will therefore take a while before new crop arrivals catch up to commitments and for this reason we have October trading at a stiff premium to December. The market believes that there is no way that new crop arrivals will be wasted on the board when October heads into its notice period at the end of September. Judging by today’s inversion of December over March the market is starting to feel the same way about the December notice period. We are not quite sure we agree with that, for several reasons. First, the crop is relatively early. Second, export sales will begin to taper off after September when major importers like China and Turkey are harvesting their own crops. Third, merchants will want to build carry into the market. Fourth, it does not take that much certified stock to force carry into the market and there is plenty of time. Cotton can be tendered on deliverer’s class almost until Christmas. So while we agree with the October inversion, we feel that the Dec/March inversion is an overreaction that will eventually get corrected, although it may take some time.

So where do we go from here? Over the last thirteen sessions December has closed within a tight range between 73 and 75 cents, forming a wedge pattern in the process. Momentum has been lacking in both directions, although we have seen a pickup in turnover this week, with today’s session accelerating to over 21’000 contracts. Sooner or later there will be a breakout from this wedge formation, which will likely generate a strong move of several cents. At this point we favor a breakout to the upside, because we feel that speculators have exhausted their selling and the trade likes the market at these lower levels. Also, from a fundamental point of view a sell-off doesn’t make sense at this juncture given the tight stock situation. Outside markets are turning more positive as well after renewed dollar weakness. The recent increase in spec short positions could provide the catalyst for a rally if buy-stops get triggered. We therefore believe that there is a good chance for a short-term rally into the high 70’s, although we don’t expect new highs being made on such a move.

Best Regards