NY futures remained on the defensive this week, with March dropping 106 points to close today at 71.85 cents.
After starting the year with a promising rally to an intra-day high of 76.77 cents - the highest reading of a spot month since April 2008 - the market has since come under steady pressure from spec long liquidation, which has intensified after a four-and-a-half month uptrend line was broken last week.
However, even though the market may have felt heavy in recent weeks, actual losses have been relatively well contained and many traders may be surprised to learn that the March contract has given up only about a cent over the last fortnight. Two weeks ago March had closed at 72.89 cents, last Thursday it was at 72.91 cents and today it settled at 71.85 cents. Strong trade buying has so far been able to provide enough support to hold the onslaught of spec selling in check.
By looking at the changes in open interest we can get some idea of the extent of this spec liquidation. On January 4th total open interest had reached a peak of 192’498 contracts, whereof March had 129’280 contracts. In the following eleven sessions we saw total open interest drop by 18’540 contracts to currently 173’958 contracts. However, the March contract, which is where most of the spec positions are located, dropped no less than 28’950 contracts, while the rest of the board actually added 10’410 contracts.
The CFTC report confirms that it was by and large ‘get me out’ spec selling into scale down trade buying that caused the market to retreat. The latest two CFTC reports show that between December 29 and January 12 the trade net short position decreased from 14.45 to 12.70 million bales, a drop of 1.75 million bales net. During the same time speculators cut their net long exposure by 1.50 million bales, from 6.40 to 4.90 million bales. Index funds saw only minor changes to their net long position, which dropped by 0.25 million bales, from 8.05 to 7.80 million bales. We need to bear in mind that the latest CFTC report is a snapshot from six sessions ago and since then there has been additional liquidation on both sides. It is probably safe to assume that since the beginning of the year the trade has covered some 2.5 million bales of its still sizeable net short position, while speculators and index funds have liquidated as many net longs.
There are a few observations we would like to make in regards to the current positions of these various market participants. First of all we believe that the net index fund position is not going to change much over the next few months. Maybe it will drop to 7.5 million bales net, but we don’t foresee any mass exodus out of commodity index products as they form part of asset diversification portfolios and they are not leveraged at all. If we are correct in our assumption, this would leave us with an estimated spec net long of some 4.5 million bales and a trade net short of around 12.0 million.
Speculators may continue to liquidate more of their remaining net long in the weeks ahead, although we don’t believe that they will go net short overall, at least not anytime soon. Last week’s ICE spec/hedge report showed that existing spec shorts actually reduced their positions slightly despite the declining trend, thus signaling that they don’t have too much of an appetite for the short side.
What we are getting at here is that even though speculators may continue to sell, it probably won’t be a match for the huge trade net short position that will eventually have to be covered. Some may say that the trade will do the same as index fund longs and simply roll its position forward. But we don’t think that’s how it’s going to work this season! Current crop and new crop are two completely different stories this year! The bulk of the trade’s net short position is tied to current crop, either as a short hedge against existing physical longs or against the 4.8 million bales of unfixed on-call sales, of which 3.4 million are on March, May and July. As current crop inventories are sold to mills or get fixed, short futures positions will be bought back, and by the time July expires there won’t be a lot of cotton left unsold. This means that compared to previous season there is much less of a necessity to hedge carryover stocks.
Also, last year at this time there was still a lot of cotton unsold at origin, whereas this season we have seen an early transition from origins to merchants. For example, last spring nearly the entire Central Asian crop was still unsold at this point and when it was eventually transacted to merchants it prompted substantial hedge selling. This season we are not only dealing with smaller crops, but since these crops are for the most part already in merchant hands, we believe that the trade will be a strong net buyer of futures between now and June.
Outside markets have been skittish in recent weeks, as many traders fear that the more hawkish stance by the Chinese government could derail the global recovery. We don’t share these concerns! First of all we need to bear in mind that the Chinese economy, and most other Asian economies for that matter, are doing extremely well at the moment. Yesterday the World Bank raised its forecast for global expansion in 2010 to 2.7 percent, up from 2.0 percent last June. And today China reported that its GDP rose by 10.7 percent in the fourth quarter and 8.7 percent for the full year, which is above the government’s 8 percent target. Retail sales rose 16.9 percent in 2009, after adjusting for consumer price increases, which is the strongest showing since 1986.
China is clearly concerned about asset bubbles and inflation and the recent measures are aimed at keeping these threats under control. However, China has stated repeatedly that one of its top priorities is to expand its domestic consumer market in order to gain more independence from exports. China’s leadership is trying to meet both of these objectives, but under no circumstances will it let its domestic economy implode.
So where do we go from here? The cotton market has been holding up relatively well amidst all the negative vibes from outside markets. Many commodities have seen their story shift from bullish to bearish – notably the grain markets – but there are always exceptions to the rule. Today the sugar market rallied to a 29-year high on bullish fundamentals and we still feel that current crop cotton has the potential to be another positive surprise over the next eight or nine months. Although the current correction may still have a little further to go, we believe that old crop futures will sooner or later resume their uptrend and trade to new highs. For those who do not like to take outright positions, the July/Dec spread offers a great way to play this tightening old crop scenario with relatively limited risk.
Best Regards