NY futures had a mixed performance last week, as March dropped 138 points to close at 94.21 cents, while new crop December advanced 81 points to close at 95.06 cents.

While the general direction of the market has remained sideways, we saw a further widening of the spreads towards full carry this week. Even new crop December is now trading at a premium to the spot month! The vanishing of the market’s inversion, which has been a feature for most of the last 18 months, is generally seen as a sign of weakness since it signals that the tight supply situation is finally easing.

Pointing in that direction as well are the recent increase in certified stock (totaling almost 86’000 including bales under review) and the large-scale cancellations that showed up in today’s export sales report. Even though there were 125’900 running bales in new Upland sales last week, they were more than offset by cancellations of 290’000 bales, with China being responsible for the majority of these reductions. The US export sales report was not all negative though, because shipments jumped to a marketing year high of 386’700 running bales. For the season, total sales now amount to 10.8 million statistical bales, of which 4.0 million bales have already been shipped.

Although these US cancellations may point to continued weakness in demand, this is not the impression we are getting in some of the Asian markets these days. After months of digesting high priced inventory, many mills are finally seeing the light at the end of the tunnel, as yarn prices have been trending slightly higher in recent weeks and some mills have even been increasing their monthly cotton consumption again. There has also been a big jump in polyester prices, which have risen by about 15% over the last three weeks in Taiwan and China. The apparent reason for this sharp advance is a short supply of PTA, the raw material of polyester. With polyester prices now quoted at USD 1.77/kg (80 cents/lb), the huge price gap that existed in relation to cotton last year has narrowed considerably.

Of note this week was also the large jump in open interest on Tuesday and Wednesday, when nearly 10’000 new longs and shorts were added. Open interest now stands at around 178’000 contracts, which is over 40’000 contracts more than two months ago. While the trade has been selling into market strength since the middle of December, index funds and speculators have been adding new longs.

We can definitely discern a different attitude among hedge funds when it comes to riskier assets like commodities. The massive monetization by Central Banks is starting to show results, as economic indicators are improving and this in turn is reversing some of the “safety trade” we have seen in the second half of 2011. Money managers, no longer content with earning just 1.8 percent on a 10-year US treasury, are moving some of their holdings back into stocks, emerging markets and commodities in the hope of finding better returns, allowing them to keep up with the rate of inflation. Since some of the money is moving overseas, it has started to put pressure on the US dollar, which is supporting commodity prices.

Copious amounts of rain have once again led to widespread flooding in Australia over the last ten days and are raising concerns in regards to quality and yield. After being off to a slow start this season, repeated episodes of cool and rainy weather have set the crop back and although there is still time to recover, the worry is that this rainy La Nina pattern will continue all the way into harvest and result in a disappointing outturn, although a record crop is still foreseen.

So where do we go from here? Over the last six weeks we have seen speculators and index funds sponsor the long side of the market, while the trade has been a strong seller into rallies. Will we see a further increase in new bets over the coming weeks or are we instead going to see either spec long liquidation or trade short covering? We can assume that index funds will remain invested on the long side, while hedge funds are not likely to abandon their new holdings in commodities either, unless they are given a good reason to do so, such as a weakening chart picture, renewed economic concerns or geopolitical issues (Iran). While profit taking by speculators is certainly a possibility, we feel that it is more likely that the trade will cover some of its shorts. Most of the trade’s short futures form part of basis-long positions and when mills enter the market to buy physical cotton, merchants typically buy back the corresponding short futures. We therefore feel that the market will be well supported on dips as mills seek additional coverage. At the same time it is not likely that the market will run away to the upside either, because there is still plenty of cotton in the system to prevent a squeeze. We therefore continue to see the market in a sideways trend in the foreseeable future.

Best Regards