NY futures came under renewed pressure this week, as March dropped 576 points to close at 86.29 cents.
The market fell to a 16-month low this week on aggressive trade and technical selling in thin trading. A look at the weekly continuation chart now reveals a well-defined ‘bell-shaped’ curve, which originated in the summer of 2010 at around 80 cents and saw its pinnacle this spring at 227 cents. In other words, the market has now basically gone full circle and there should be a decent layer of support waiting in the 80-84 cents area.
Typically we would have expected to see heavier trading volume on such a pronounced break in the market. However, with the exception of Monday, when volume briefly spiked to 18’000 lots, the remainder of the week saw turnover of just 11’000 to 14’000 contracts. Unlike in some other markets, where deleveraging by speculators was blamed for the sharp decline in prices, the cotton market can’t use this excuse, because a) speculators don’t have a large position to begin with and b) open interest went up this week. The fact that open interest was rising indicates that it was new selling rather than long liquidation that weighed on the market.
Apart from perhaps some new technical selling based on a weak chart, the trade seemed to be the main driver behind this move, as holders of long positions in non-US cotton were buying protection, either by selling futures, buying puts and/or selling calls. With speculators conspicuously absent from the cotton market at the moment, there was simply not enough on the other side to absorb the selling, which caused prices to drop into a vacuum on relatively low volume. The USDA report of last Friday seemed to be behind this renewed sense of urgency among traders to seek protection against unsold positions, and since forward business in the physical market is still difficult to materialize, the futures and options market seems to be the logical choice.
According to the USDA, the seasonal production gap in the rest of the world (ROW) has now all but disappeared, with ROW production at 107.6 million bales basically matching ROW mill use of 107.7 million bales. This is in stark contrast to a deficit of 13 million bales last season and a 26 million bales shortfall two years ago. In theory, the rest of the world doesn’t need any cotton from the US, but since the US has already managed to sell most of its exportable surplus overseas (10.5 million bales in commitments with another 1.3 million in optional sales), it has transferred the burden of pushing sales to other origins around the globe, which is why we have recently seen so much price pressure from a variety of different growths.
Fortunately the Chinese Reserve has been relieving the pressure somewhat by lifting a sizeable amount of the seasonal surplus off the market. As of today, the Reserve has bought around 7.2 million statistical bales in the domestic market and an estimated 4.5 million bales in the international market. In other words, the Chinese Reserve has now basically absorbed the entire global surplus, which according to USDA numbers amounts to 12.1 million bales. However, the problem with this Chinese support is that only a part of it has been directed at the international market, with the US being the main beneficiary. Most other origins, such as India, CIS, Brazil, Australia and the various African growths, have only seen a limited amount of business from China thus far.
This may change at some point in the future, because at least from a statistical point of view it seems that China will have to import quite a bit of cotton next year. According to the USDA, China produces 33.5 million bales this season, while mills use 45 million bales. That amounts to a shortfall of 11.5 million bales. Add to that the 7.2 million, which the Reserve has lifted off its domestic market so far, and the shortfall rises to 18.7 million bales. Therefore, unless the Reserve makes these bales available again later in the season, the difference has to be made up by imports.
Among all the bearish hype surrounding the latest USDA report, it seemed to have gone largely unnoticed that the USDA has increased Chinese imports by 1.5 million bales to 15.5 million bales, which, if it materializes, would be supportive to the market. The big question is of course the timing of these potential imports. Many of the non-US origins that are currently sitting on their crops are becoming increasingly nervous and are either lowering their offering prices or are seeking protection in the futures market.
From a technical point of view the futures market is sending rather mixed signals. On the one hand there is this very pronounced downtrend, which has seen prices drop from a high of 227 cents in early March to a current price in the mid-80s. On the other hand we have seen an inverted spot month throughout this entire decline, which signals tightness in the cash market. Indeed, the US cash basis has remained relatively firm as shippers try to lock up available supplies against their large unshipped book of commitments, while futures are being pressured by the need to hedge mainly non-US cotton that has yet to be sold.
So where do we go from here? Markets don’t like uncertainty and right now there is plenty of that, both in the global financial markets and in the cotton market. With deflationary forces once again taking the lead in this ongoing dance between deflation and inflation, when will central banks come to the rescue with another round of money printing? The ECB doesn’t seem to be in any hurry, as Germany is trying to put the brakes on more money printing, although sooner or later there will probably be no other alternative! The same goes for the Fed, who has taken its foot off the pedal over the last six months, but who will likely resume its money printing as cracks in the system start to appear.
Among the many uncertainties the cotton market is facing, Chinese import quotas are probably at the forefront. Without sizeable imports from China, prices of non-US origins are likely to drop further, as the holders of these unsold crops don’t have nerves nor the financial means to sit on their cotton for too long. In the short-term we may therefore see lower prices, but it may not be a good idea to get too extended on the short side.
In the longer-term we see strong chart support, the potential for Chinese imports and lower plantings next season acting in support of the market, although a return to a bull market seems unlikely anytime soon.
Best Regards
