NY futures had another explosion to the upside this week, with December gaining 597 points to close at 121.68 cents, while March rallied 859 points to close at 118.80 cents.
Cotton futures reached their highest peak since trading began on the New York Cotton Exchange in 1870, with the December contract posting an intra-day high of 130.50 cents and a closing high of 129.59 cents on Tuesday. Only during the Civil War (1861-1865), when a blockade imposed by the North prevented cotton from being shipped to Europe’s textile mills, were cotton prices higher at 189 cents.
But the NY futures market wasn’t alone with its record-breaking performance, as the A-index posted an all-time high of 147.00 cents on Wednesday and the Chinese spot futures contract closed at a mindboggling 204.67 cents today. As we have stated before, it is the physical market, led by an out-of-control Chinese market, which has been the driving force behind this rally. In only a little over three months, since July 21, the A-index has now gained an incredible 64.30 cents, while December futures have barely been able to keep pace, rallying ‘just’ 48.67 cents.
We still believe that we need to look at the physical market for clues as to where the futures market might be headed – not vice versa. As of today, mills were still willing to pay 140-142 cents for prompt high grades landed the Far East, while prices for first quarter shipments were in the 132-136 cents range and Brazilian/Australian high grades for summer 2011 shipments are currently in the 124-130 cents range. From that it follows that NY futures should be no more then approximately 14 cents below these prices, otherwise they will present an arbitrage opportunity. When comparing futures and cash prices we need to bear in mind that certified cotton taken up against the December contract probably wouldn’t ship until early February.
Therefore, if we look at 135 cents for Feb/March shipment, December futures make sense at 121-122 cents. Earlier this week, when the December contract briefly rose to 130 cents, it was clearly overvalued in terms of what mills were willing to pay for Feb/March shipment at that time and the sell-off since then was simply an effort to bring values back in line. On the other hand, if spec selling were to force spot futures too far below physical prices, similar to what happened after the key reversal two weeks ago, then the trade would happily step in as a buyer.
For futures prices to trend lower we first need to see the cash market soften, which hasn’t happened yet. However, the widespread panic we have been witnessing recently has finally started to subside and the old saying that “the best cure for high prices is high prices” may still hold true. While finer count spinners are apparently still able to make ends meet, the open-end sector is hurting, because the raw material component represents a higher percentage of total cost. We have even heard of one instance where an open-end mill decided to halt further production for now and to sell its existing yarn inventory at a steep profit. The level of demand destruction is difficult to gauge, but we have probably reached a point at which an increasing number of mills are starting to resist these higher prices.
As we have learned over the past few years, macroeconomic developments and the resulting money flows have a greater impact on commodity prices these days than ever before. We have repeatedly talked about how a weakening US dollar can lead to higher nominal prices and in that regard we are getting increasingly worried about what we are currently seeing in the US bond market.
There is a lot of talk about more ‘quantitative easing’ by the Federal Reserve these days. What this means in a nutshell is that the Fed will create money out of thin air to purchase treasury bonds in order to keep interest rates low, which in turn is supposed to jumpstart the economy. Many of the so-called bond experts and gurus that are quoted in the financial media make it sound like the Fed has a choice in how much treasury debt it is going to buy. This is not entirely accurate! Gross Public Debt is now approaching 14 trillion dollars and keeps rising by around 2 trillion dollars a year. So far “the market”, a large number of which consists of foreign Central Banks, has been absorbing this escalating debt issuance, often in an effort to keep their own currencies from appreciating too much against the US dollar.
However, there is a limit as to how much longer investors and foreign Central Bankers are able and/or willing to keep this game going. There will be a time, probably sooner rather than later, when the market will no longer absorb all this extra debt and it may not even be willing to roll existing debt forward. When that happens the Fed will have no other choice but to take on all the debt the market is not willing to underwrite. Imagine what would happen to the US dollar if the Fed had to monetize several trillion dollars of debt over the coming years!
It is no coincidence that the Fed is trying to convince investors that deflation is the problem, since it wants to keep them from leaving the bond market. Once the market fears inflation, it will no longer be as willing to hold on to bonds, especially at these lousy yields. However, with commodity prices rising sharply and global equity markets rebounding, it is becoming increasingly more difficult to keep investors in the bond market. In normal times we would see interest rates go up in order to attract investors, but with an economy and a housing market as fragile as they currently are, that won’t be an option. This means that the Fed may have to step in as the buyer of last resort and monetize debt at unprecedented levels. The price to be paid for this folly is a further debasement of the US dollar, which in turn will translate into even higher nominal commodity prices over time.
So where do we go from here? Based on where physical prices are trading right now the December contract is more or less fairly valued. Forward pricing currently suggests that physical prices will gradually weaken as we head into the first and second quarter, but this would only make sense if demand destruction were to erase the seasonal production gap over the coming months. However, should demand prove to be more resilient than anticipated or if the Chinese Reserve came in to absorb a million tons or two into its stock, then the third quarter might turn into a rather explosive affair.
Best Regards