NY futures had a mixed performance this week, as December gained another 268 points to close at a 'synthetic' 104.60 cents, while March advanced just 26 points to close at 100.72 cents.
The market has covered a lot of ground since last Thursday, as December first dropped by nearly 600 points, only to resume its uptrend thereafter with a 900-point rally. The standout feature this week has been today’s dramatic widening of the Dec/March inversion, as December exploded from yesterday’s 106-point premium to 388 points, based on today’s synthetic close. Traders were scratching their heads as to why December went into melt-up mode while the rest of the board kept limping behind.
Maybe it was the excellent US export sales report (647’000 running bales for both marketing years) that set the ball rolling, but this should have lifted all current crop months in concert. The more likely explanation is that a large purchase of out-of-the money call options caught traders by surprise. In particular there were 3’750 of the December 116 strike calls traded, with a large hedge fund reportedly buying them.
The keen interest in cotton by speculators and hedge funds is not surprising given the current macroeconomic environment, in which nearly all commodities are rising while the US dollar keeps falling. Although the current bull market in cotton has its foundation in an extremely tight supply/demand scenario, the ongoing debasement of the US dollar is certainly playing an important part as well.
Today the US dollar traded at an all-time low against the Swiss Franc, a 27-year low against the Aussie dollar and a 15-year low against the Japanese Yen. While investors are increasingly seeking out these currencies, because they have stronger fundamentals in regards to trade and/or fiscal policy, we have also seen a push to new highs in gold, which is regarded as the ultimate hard currency these days. Over the last decade gold has enjoyed double-digit percentage gains every single year, as it has been climbing from 260 dollar/oz to currently around 1340 dollars/oz.
Since gold is both a commodity and a ‘safe haven’ investment, it has been gaining popularity in a financial world that sees debt and deficits spiraling out-of-control. In the United States, the world’s biggest debtor, gross public debt has soared from 5.8 trillion to 13.5 trillion dollars over the last ten years, while total credit market debt has gone from 29.3 trillion to 52.2 trillion since 2001. Unfortunately the ongoing fiscal and trade deficits of a combined 2 trillion dollars a year keep adding to this debt problem and there is no immediate turn of events in sight.
Following the financial crisis of two years ago we have seen a slight contraction of household and business sector debt, which prompted the government to proactively boost its debt levels to keep the credit bubble from imploding. The deleveraging in the household and business sectors has allowed the Fed/government to print money without causing too much inflation at this point, but the rapidly increasing debt-to-GDP ratio is not boding well for the future. This problem is by no means just limited to the US, although its size in absolute terms dwarfs that of other economies.
More and more investors are realizing that the printing press is not a viable solution to an economic problem, since it will ultimately destroy the currency. Smart money therefore keeps diversifying into tangible assets like commodities in an effort to preserve value and there seems to be no end to this trend in sight anytime soon. Interestingly, when we express the price of cotton, or just about any other commodity, in ounces of gold, we are not even close to historic highs yet. For example, at the peak of the October 2003 bull market a bale of cotton was worth about one ounce of gold, while in March 2008 a bale of cotton could be bought for about half an ounce. Today, believe it or not, it takes only 0.38 ounces of gold to own a bale of cotton, even though in nominal terms we are at the highest level in 15 years. We are getting similar outcomes when we compare cotton to a 10-year chart in Swiss Francs, Aussie dollars or the Japanese Yen. In other words, if we want to compare today’s cotton market to the ones of years past, we have to take into account that its denominator has changed, quite considerably so. This may explain why physical prices have been allowed to trade much higher than at anytime in the past, without causing a major uproar from the mill sector.
So where do we go from here? Last week we felt that the arrival of the Northern Hemisphere crops would allow the market to settle into a trading range, but after today’s performance we are probably looking at new highs in the days ahead. A lot will depend on how China’s market will react when it resumes trading after its 7-day holiday, but based on the strong physical prices that have been paid in various export markets this week, we don’t expect to see a lot of price pressure at this point. In fact, physical prices have been running so far ahead of the futures market recently that this latest rally may simply be an attempt to catch up.
However, we do believe that this widening inversion between December and March is unwarranted, since the crop is moving in very fast and there will be plenty of cotton available by the time December heads into the notice period. The notion that the market cannot afford to ‘waste’ cash cotton to the board is not a valid one in our opinion, because regardless of how desperately mills need US cotton, there is a logistical limit as to how much can be shipped on a weekly basis. This means that there will be a sizeable amount of stocks sitting in US warehouses over the coming months, which can temporarily be used as certified stock while it is waiting to be shipped.
Best Regards