NY futures bounced back this week, with December gaining 394 points to close at 102.57 cents.

A clearly oversold futures market finally managed to rebound this week, but not before making a new low of 93.20 cents on Tuesday. Once this latest wave of selling was out of the way, the market rallied by more than 1100 points in less than 24 hours to a high of 104.44 cents, thereby essentially closing the gap that was left open between 103.45 and 104.46 cents.

Open interest increased by nearly 4’800 contracts over the last two sessions, indicating that it was speculative buying that sponsored the advance, while the trade was likely selling into it. Although the move may look impressive to a technical trader, since it was validated by higher volume and open interest, the trade doesn’t seem to believe that there is any merit for higher prices at this point, based on what is happening in the cash market.

Other than China, which has been a decent buyer on recent dips, nearly all other markets have remained relatively quiet. There are simply too many problems with counterparty performance throughout the entire supply chain, from merchants all the way down to retailers, which need to get sorted out before anyone is seriously thinking about new business. Most firms don’t even know what position they currently own, since so many contracts are in limbo.

This massive drop of over a dollar in less than 4 months has sent shockwaves through the entire industry and we estimate that damages from the non-performance of contracts could range in the hundreds of millions of dollars. In a way we are experiencing similar dynamics as during the financial crisis, with traders trying to de-risk and de-leverage their positions. Since the tight statistical situation of earlier this year lured most traders into operating from long positions, the sudden lack of bids in the physical world has made it very difficult to escape, which is why many traders have resorted to selling the futures market.

However, selling futures short at these low levels harbors a lot of dangers. It seems to have gone largely unnoticed by the market that the certified stock has dropped to just 15’174 bales this week, with nothing awaiting review. That’s the lowest the certified stock has been since last November, when the bull market was gathering steam. We have long held the belief that the US will literally run out of cotton by the time new crop arrives and that the situation is even tighter than a year ago due to a smaller crop and higher forward commitments. What’s different this time is that the rest of the world will probably have enough cotton to prevent any mad rush, but that doesn’t necessarily solve the problem of those who are short in the US.

Let’s assume that the US is indeed going to run out of any physical inventory by some time in late October or early November. Let's further assume that basically all of the export commitments currently on the books were sold at prices higher than today’s market. Since the crop is likely to arrive later than normal, we could therefore see a mad scramble by merchants to make their October, November and December shipments in time to avoid further problems with their clients. Other growths won’t be available in sufficient quantities at that time to offer a viable alternative. To us it all adds up to a potentially explosive setup going into the December notice period. Those who are trying to ‘hedge’ their foreign growths long by shorting December at these low levels may therefore find themselves in an “out of the frying pan into the fire” situation.

Markets don’t like uncertainty, and right now we have plenty of it, not just in regards to contract performance, but also on a macro scale with the US and European debt crises. While the Europeans seem to have found a way to kick the can further down the road, US lawmakers are hopelessly deadlocked regarding the debt ceiling. Most traders believe that it is business as usual and that a last minute compromise will be found, which will defer the problem into the future. This is why the markets have stayed relatively calm, with treasury bonds showing no signs of even the slightest panic.

However, we feel that this is not your usual budget debate, since the “Tea Party” Republicans seem determined to stay their course, which could mean that at best we’ll get an extension until early next year. This would probably unsettle the financial markets and could lead to unintended consequences. We believe that either way the repercussions are not going to be pleasant for the financial markets. If a deal is agreed on and the debt ceiling is raised, it means just more money printing and a further weakening of the currency. If no deal is reached or budget cuts are too deep, it would be akin to taking a patient off life support, which means that the Fed would have to step in rather quickly with a new stimulus program (= money printing) to prevent the US economy from going into a tailspin.

So where do we go from here? Although the cash market is lethargic as traders are still assessing the damage this price collapse has caused, and everyone tries to get a grip on the real level of demand, we believe that NY futures have fallen low enough and that any further dips should be bought. Judging by retail sales around the globe we don’t believe that cotton demand has collapsed to the degree that the present sentiment may lead us to believe. Once the current mess has been sorted out and a more normal pipeline flow has been restored, we should see prices stabilize and possibly even rebound somewhat. In particular we would be careful in shorting December futures, because we feel that this could turn into a rather costly “bear trap”.

Best Regards