NY futures came under pressure this week, as July dropped 307 points to close at 78.21 cents, while December fell 268 points to close at 76.40 cents.
A look at the chart tells us that the market is in a decidedly negative mood at the moment, as July has closed lower than it opened for eight sessions in a row, giving up 476 points in the process. In seven of these eight sessions July closed right at or near the low of the day, which confirms that the sellers are firmly in control at the moment. Open interest in July has declined by about 25’000 contracts during this recent decline, while December open interest has risen by about half that amount or 12’000 contracts. The open interest of both months amounted to around 80’000 contracts this morning and after today’s session December will have taken over as the lead month in terms of open interest.
Hedge fund selling seems to be behind this latest sell-off as worries about waning global demand for commodities have once again prompted traders to reduce their long exposure. An increasing number of analysts feel that China may not be able to sustain its strong economic performance, which has been pulling the global economy along since the financial crisis unfolded. China is the largest consumer of industrial commodities with the exception of crude oil. For example, China accounts for more than a third of global demand in industrial metals like copper, zinc and aluminum.
When the world economy hit the skids in 2008, the Chinese government accelerated infrastructure spending and loosened monetary policy, which helped to fuel a building boom. This has led to an enormous appetite for industrial commodities in 2009 and caused prices to rise substantially. Fearful of inflation and a housing bubble, the Chinese government has since reacted by tightening monetary measures in an effort keep the economy from overheating, which is starting to show its effects. The Chinese stock market has declined about 20% in the last six weeks alone and the CRB is off by about 10% so far this year, with most of that drop occurring over the last four or five weeks. Some analysts believe that prices for industrial metals could fall 30-40% from current levels over the next twelve months and if that were to happen it would probably drag the entire commodity complex lower.
Whether speculators are overreacting or not remains to be seen. It is not the first time this year that specs have cut their long exposure in commodities, only to put it back on a few weeks later. However, this time around the mood seems to be more somber since the European debt crisis has added another element of uncertainty. The CFTC report of May 25 showed speculators still at 4.8 million bales net long in cotton futures and options, but that position may have been cut by about a third since then. Nevertheless, speculators have it in their power to keep the futures market under pressure if they continue to liquidate or go short.
Despite one of the tightest cash markets in years, which had the potential to cause a short squeeze, it is now the spec longs that are headed for the exit. Although inventories remain tight, the certified stock of 1.1 million bales has apparently done its job as a deterrent. There is still a possibility that the certified stock, or at least part of it, could find a home overseas now that it is back in line with landed Far East prices, but unless China steps up to the plate it probably won’t happen.
Today Cotlook reported that China’s commercial stocks were still at 3.0 million tons at the end of April, which would be significantly higher than last season. If that were true then China should have more than enough cotton to make it to new crop, considering that there are still around 1.4 million tons in the Reserve as well. What seems odd though is that Chinese prices remain near record levels. Both the CNCE and the Zhengzhou futures markets are still at around 120 cents, while the CC Index is at 117 cents. One thing that hasn’t changed over the years is that no one seems to have a firm grip on Chinese statistics.
So where do we go from here? Speculators are the force that tips the scales. Index funds work from a permanent net long position, while the trade is typically operating from a futures net short. When specs are net sellers and the trade is not keen in buying the same amount on the other end, or at least not until prices become cheaper, then the market will be forced lower. The opposite has been the case when specs were net buyers and the trade struggled to add more shorts.
Although the trade needs to cover its remaining July shorts over the next three weeks, it is replacing some of these shorts in December due to the fact that the US crop looks very promising at the moment. Growers are keen to sell near 80 cents, while mills don’t want to pay these forward prices.
We believe that trade support will be there in July from current levels on down, but if speculators continue to liquidate in greater numbers or intend to short commodities, then the market could face more downward pressure. The certified stock could still come into play as an element of surprise if buyers can be found, although that is a big IF at the moment. Even though the market may look attractive at current levels, we prefer not to buy it on this kind of weakness and shall wait for a trend reversal first.
Best Regards
