NY futures exploded to the upside this week, with December rallying 1427 points to close at 118.87 cents (synthetic), while March advanced 1339 points to close at 114.75 cents (synthetic).
It has been a historic week, because December’s synthetic close of 118.87 cents marks the highest futures price ever, eclipsing the April 29, 1995 high of 117.20 cents, and the market doesn’t look like it’s done breaking records just yet. We have now entered what appears to be the blow-off phase of this rally, with prices ascending in parabolic fashion. As shorts are being forced to run for the hills, what typically follows at this point is a “climax top”, when prices accelerate out of a base and get overextended. It is not unusual to see the market rise 25-50% in just a couple of weeks in such a situation. The short-covering is often so strong at this stage that it will create “exhaustion gaps” on the chart, where the lows of the day are higher than the previous day’s highs. This typically occurs after the market has already made a significant move to the upside.
The fuel during this phase is short-covering. According to the latest CFTC report, the trade was still 12.6 million bales net short as of October 5. Although that’s nearly 3 million bales less than the 15.5 million bales net short on September 14, it is the gross short position that deserves attention since it has remained stubbornly high. As of last week, there were still 23.26 million bales in outright trade shorts, just slightly less than the 23.75 million bales on September 14. In other words, the reduction in the trade’s net short position was not the result of short-covering, but was mainly due to an increase in outright trade longs, which presumably were established by mills trying to protect unfixed on-call commitments.
It becomes quite obvious why the market is melting up when we quantify how much margin money has been sent to New York over the last three months. Based on an average trade net short position of 12.5 million bales, the 40-cents move translates into 2.5 billion dollars, and if we measure it based on the average gross short position of roughly 20.0 million bales, we are talking about 4 billion dollars. It would be a stretch to envision that the trade has that kind of margin money readily available, especially since there is hardly any collateral at the moment.
What we are witnessing in the futures market right now has a lot more to do with a shortage of money than a shortage of cotton. The way the action unfolded on the board this morning seems to confirm that, because it was December that led the charge, while March, May and July appreciated much more slowly. Spreads were very active today, as Dec shorts tried to escape the front squeeze by rolling their shorts into later months. Only once Dec was locked the limit did we see the back end catch up. If the market was concerned about the statistical shortage, there would be much more buying interest in the back months, since the perceived statistical tightness won’t materialize until the second and third quarter next year.
We cannot remember a time when traditional price relationships have been more out of kilter than over the past couple of weeks. We typically have the A-index at a premium of around 5-7 cents above the spot futures contract and it rarely ever exceeds 10 cents. However, recently this spread has been as wide as 16 cents on a couple of occasions, as cash prices have held very steady even when NY futures were showing some weakness. Today the futures market narrowed this spread considerably and based on December’s synthetic close of nearly 119 cents we are now once again getting closer to the traditional basis between the A-index and spot futures. The A-index stood at 124.60 cents this morning, although it is likely to bounce higher tomorrow. Nevertheless, we wouldn’t be surprised to see NY futures go from being ‘undervalued’ in regards to cash prices to overtaking them over the next few sessions as a result of this explosive move.
Another price relationship that has gone awry lately is the one between the New York and Zhengzhou futures markets. What used to be a fairly consistent 25-30 cents spread (Zhengzhou over), has widened to about twice as much today, since the nearby futures month at the ZCE in China closed at 177 cents.
So where do we go from here? It is anybody’s guess at what level this blow-off move will exhaust itself. It could be within just a few cents or it may be another ten, twenty cents from here. It will to a large degree depend on the staying power of the shorts. Based on how much money they have already spent over the last three months, we can’t imagine that there is a whole lot left to defend short positions. Therefore, the higher the market goes, the more these shorts are getting forced out. It will be interesting to see how the cash market reacts over the next few days. Will cash prices finally encounter some resistance now that the Northern Hemisphere crop is moving in or will they continue to lead the way higher? If cash prices were to settle down, it would eventually cap the futures market as well, because once December becomes pricey relative to cash AND has a 600-point premium to March, it will invariably attract cotton to the board. Once the panic blows over, we expect to see cash and futures prices realign themselves to a more traditional basis, although we may have a very volatile up and down move ahead of us before we get there.
Best Regards
