NY futures extended their rally this week, as December added another 97 points to close at 90.46 cents, while March advanced 113 points to close at 89.08 cents.

Returning from the long Labor Day weekend, traders were greeted to news that Tropical Storm “Hermine” had unexpectedly popped up in the Gulf of Mexico over the weekend and was posing a threat to cotton areas in the region. Combined with reports about some panicky trading in China it prompted the market to jump to new highs on Tuesday.

However, while “Hermine” dumped up to ten inches of rain on South Texas, where about two-thirds of the crop has yet to be picked, it only skirted the outer areas of the Mid-South. That’s good news since most of that crop is currently being defoliated and harvest is gaining momentum. Although we have seen a string of tropical systems in recent weeks and there are several more threats looming in the Atlantic, the impact on cotton has been minimal so far. Since the crops in the Mid-South and Southeast are reportedly ahead of schedule this season, we may see a swift harvest if the weather continues to cooperate.

This may lead to an erosion of the weather premium and calm the nerves of traders who have been on edge due to the existing pipeline shortage. In other words, once the crop moves in we may see a shift in market psychology, at least temporarily. Although the tight statistical situation won’t be resolved until we either see a rationing of demand or a large 2011/12 crop, the fact that warehouses are getting filled with bales over the coming weeks should reduce the sense of urgency among traders. And once the cash market begins to calm down, the futures market will invariably follow suit.

The market has now gone up for eight straight weeks without much of a pause, as firm cash and futures prices have been reinforcing each other on the way up. Looking at the chart we still have a very strong bullish trend in force, fueled by continuous speculative buying. Open interest in futures has increased by over 72’000 lots in less than two months, going from 153’514 contracts on July 13 to 226’095 contracts as of this morning. That’s a tremendous amount of buying, with speculators large and small wanting a piece of this bullish cotton story. What may be a concern for the bulls is that cotton is suddenly all over the mainstream press, which is often seen as a contrarian sign since the smart money has already made its move while smaller investors are getting in at elevated levels.

In order to keep this rocket of an uptrend going, the market is in constant need of additional fuel, otherwise it will eventually reach a point of exhaustion. We are not suggesting that we have reached this point just yet, but we need to be on the lookout for potential signs of trouble and try to anticipate what might prompt speculators to take profits. The fact that the Oct/Dec inversion has been reverting is probably seen as an early warning sign by speculators. However, since speculators believe that “a trend, once established, is more likely to continue than to reverse”, they will likely stay with it until a reversal pattern has been completed.

Tomorrow we will get the latest set of USDA numbers and most likely they will be slightly bullish, since we expect to see crop reductions in China, Pakistan, Brazil and some African origins, while world mill use should be more or less maintained. There is also the possibility of a further reduction in Chinese stocks going back several seasons. Just this week the CCA stated that at the end of August its members reported carryover stocks at just 205’000 tons, which amounts to just a little more than a week of mill use. Although this number does not include government reserves, consignments and mill stocks, it is still a good indication of how tight supplies must be in China at the moment.

So where do we go from here? We believe that most of the bullish news is baked in the cake by now. However, adverse weather over the next few weeks could still provide more fuel to this bull market. On the other hand, if crops move in without any major setbacks, we are likely to see a temporary top. Previous bull markets tell us that the market typically struggles to advance through harvest. In 1995, Dec topped out around 95 cents at the end of September and in 2003 it stalled near 85 cents at the end of October. This is not to say that this bull market is over, but we may see it transition to a sideways trend for several months before resuming its uptrend in the second and third quarter. Bears shouldn’t get their hopes up too high though because underlying support remains quite solid thanks to the 9.67 million bales of unfixed on-call sales.

Best Regards