NY futures continued to slide this week, as July dropped 509 points to close at 145.96 cents, while December fell 1281 points to close at 120.18 cents.

Although US crop prospects continued to deteriorate, as West Texas and parts of the Southeast are still suffering from drought, with no significant rain in sight, the market’s focus has been elsewhere this week.

It was the Greek debt crisis that has been unnerving traders, as there is growing concern that Greece could turn into another “Lehman Brothers” and trigger a chain reaction of negative credit events. Yields of 2-year Greek notes traded at over 30% and credit default swaps for Greek, Irish and Portuguese debt all surged to record levels today. French and German banks as well as pension funds would be hurt the most by a Greek default and Moody’s has already threatened to downgrade the rating of several French banks.

But Greece is just the tip of the iceberg, as Ireland, Portugal, Belgium and even Italy and Spain are all facing serious debt issues of their own. In the case of defaults, the institutions that insured sovereign debt would take a serious hit and this in turn could trigger another de-leveraging phase and credit crunch. Only this time around it would become a lot harder for central bankers to reflate the bubble.

The uncertainty in Europe and the strengthening US dollar has prompted many money managers to move to a “risk off” position by reducing bets in stocks and commodities. The silver lining for cotton in this regard is that speculators and index funds currently own much smaller net long positions in cotton futures and options than they did three years ago, which should mitigate the impact of any de-leveraging.

However, it is not just these macro events that have been weighing on the cotton market, but demand in the physical market has basically been non-existent lately. Mills are still trying to digest high-priced inventories of cotton, yarn and fabrics and with the huge price swings we have seen in recent months, there is a lot of confusion as to where a sustainable price level for cotton really is.

The latest US export sales report was actually a pleasant surprise after 11 consecutive weeks of negative numbers in current crop. Net sales of Upland and Pima cotton amounted to 10’300 running bales for this season and 39’200 running bales for next marketing year. Shipments of 227’100 running bales reduced the outstanding balance for the current marketing year to just 2.2 million running bales (last year 3.4 million bales) and as we have stated last week, at the current pace of shipment all the inventory would be gone by September.

This current tightness in the US physical market is being reflected by the July/Dec spread, which has widened from 1806 to 2578 points this week. Maybe we are seeing a repeat of what happened with the May/July spread, where a widening inversion rather than a rally in the spot month reflected the short squeeze. As of this morning there were still 26’694 contracts open in July, with only five sessions to go before First Notice Day on July 24. Although the market feels extremely weak at the moment, July shorts need to be careful not to overstay their welcome, since we still believe that there is not enough cotton available to fulfill existing commitments until new crop. In other words, there may be a taker or two waiting to move cotton off the board.

As we have mentioned at the beginning, the situation in West Texas is getting worse week after week. According to the National Weather Service, the first two weeks of June (June 1 – 14) have been the warmest on record in Lubbock and the second warmest in Childress, with the average daily high measuring 10 degrees above normal in Lubbock and 13 degrees above normal in Childress. Since only a trace of rain has fallen in Lubbock during these two weeks, it has also been the driest period on record. Abandonment estimates are approaching 35-40% as most dryland will likely not get planted, but under the current conditions even irrigated acreage is showing adverse effects from this extreme drought. More triple-digit heat is forecast through the weekend, with temperatures reaching as high as 110 degrees.

So where do we go from here? This is what we know – remaining supplies in the US are very tight and may not be enough to meet existing export commitments until October, plus the coming US crop is in trouble and may yield several million bales less than what was expected just a month or two ago, with numbers of less than 15 million bales already being mentioned.

And here is what we don’t know – how much demand destruction has there been and at what level is annual demand nowadays? Is it at 119 million or is it at 114 million bales? Is the current lull just a reflection of the price-adjustment process or is there something more worrisome going on? With the economies in the US, Europe and even China facing some serious issues, could there be another ‘black swan’ event around the corner? The market doesn’t like uncertainty and currently there is plenty of it! Also, bull markets are typically demand-driven, but based on recent sales activity it is difficult to make the 'demand case' at the moment. Until we have some answers to the above questions, the market is likely to remain on the defensive!

Best Regards