The NY futures market continued its powerful rally this week, as March gained another 405 points to close at 76.97 cents, while December advanced a more moderate 64 points to close at 73.34 cents.
The market is now firmly back in the grip of the bulls after the spot month has rallied more than 1000 points in a matter of just eight sessions. While cotton fundamentals have been friendly for quite some time, the technical picture has now aligned itself in that direction as well. Momentum is bullish, short- and long-term moving averages are all pointing higher and daily, weekly and monthly charts are displaying strong reversal patterns after the recent sell-off. When looking at a candlestick chart, which illustrates the balance of power between buyers and sellers, we notice eight consecutive white candles, indicating that the market has closed higher than it opened for the last eight sessions. In other words, the buyers have a strong upper hand at the moment and that is not likely to change anytime soon.
Last week we tried to explain the current ‘imbalance’ that exists between buyers and sellers. Although there are of course always an equal number of longs and shorts open at any given moment, the timing of when these positions become active, either by liquidating, increasing or rolling out, becomes an important part of the analysis. To quickly recap the situation we are in right now, we basically have a big block of index fund net longs opposing a large block of trade net shorts, with relatively little spec participation outside of that.
Index funds have strict rules as to how and when existing positions will be rolled forward. In general the May position will be rolled into July at the end of March/early April and the July position will be rolled into December at the end of May/early June. In between these rolling periods the index fund net long position remains relatively inactive.
Therefore, if trade shorts decided to go square, they would either have to wait until one of these rolling periods provides enough liquidity or else they need to find someone to take the other side. Another problem is that there are not many potential new shorts out there at the moment, since the trade will be a strong net buyer of futures itself until the middle of June (July expiration) and speculators are more interested in joining this bullish trend than betting against it. In short, we have a lot more traders interested in buying the market than vice versa, be it to close out basis-long positions that are being sold to mills, be it to offset mill fixations against which futures have previously been shorted or be it to establish new spec long positions.
What we have right now is a very tight fundamental situation in current crop, which will have no remedy until October/November, when the next Northern Hemisphere crop will bring relief. However, in terms of the futures market, all of the action regarding current crop will be condensed into the next four months, because by the middle of June all of the futures, options and unfixed on-call positions related to March, May and July will have to be dealt with.
A big part of the problem lies with the on-call position. Although the market was trading below 70 cents for a couple of weeks and some sales have been fixed, we have actually seen a net increase in unfixed on-call sales to 5.6 million bales as of February 12, of which 3.3 million were on March, May and July. In other words, mills have missed a golden opportunity to fix the price on their outstanding commitments and are now once again chasing after the market. Between now and June mills will have to fix no less than 33’000 contracts in a market that will become less and less liquid.
It certainly didn’t go unnoticed by traders that the cotton market was able to divorce itself from some of the negativity in outside markets, like a stronger dollar index or the weakness in grains. Again, this has to do with the fact that most of the spec net long position has been liquidated during the previous sell-off and we therefore don’t have a lot of specs left that might react to what happens in the outside markets. Index funds are only to a limited degree susceptible to outside forces and the huge trade short has other things to worry about over the next three or four months. We therefore have a cotton market that is running its own show at the moment, similar to the dynamics we have seen in the sugar market for example.
So where do we go from here? Although nearby futures have shot up ten cents straight and a correction may seem more than overdue, there is no guarantee that the market will comply. This is a dangerous bull market that is being fueled by a large number of trade shorts trying to get out and specs longs trying to get in, with not much liquidity on the other side. Traders are waiting for dips, but eventually they find themselves chasing the market after several unsuccessful attempts to catch it.
As far as the spread between current crop and new crop goes, we seem to have the proverbial “one bird in the hand is worth two in the bush” scenario. It doesn’t do mills any good to know that there will be plenty of cotton in November if they still need to cover or fix a large amount of supplies between now and late summer. This should keep May and July well supported, while December may see pressure from forward contracting of new crop. Although the May/Dec and July/Dec spreads have inverted to 479 and 455 points today, we expect these inversions to expand further over the coming months.
The current set-up reminds us of previous bull runs, with the events of early 2008 still fresh on traders’ minds. Whether we will see a similar occurrence this time around remains to be seen, but we would advise anybody who is still short May or July not to take any chances and to get out of harms way or at least buy some protection.
Best Regards