NY futures closed mixed this week, as May lost another 305 points to close at 78.77 cents, while December actually gained 44 points to close at 75.13 cents.
As expected, the most active months continued to let off some steam after their steep advance during February. So far this correction has been quite orderly and we still haven't seen much liquidation as overall open interest has been well maintained near the recent high mark. With the trade mostly on the sidelines, it was primarily a tug of war between speculators over the last ten days, as both longs and shorts have been bolstering their positions. The ICE spec/hedge report (futures only) showed that spec longs added 12’091 contracts, while spec shorts increased their position by 8’308 lots last week. The more aggressive stance by spec shorts may have been the main reason for the momentum shift to the downside.
The question is how far down the market will have to go before the trade is willing to step back into the game. Mills were unwilling to chase prices higher and have instead continued to secure supplies by buying on-call. Last week alone the unfixed on-call position increased by an incredible 723’200 bales net, whereof 186’800 bales were based on May and July futures. This means that we now have 6.9 million bales in unfixed on-call sales, with over 3.6 million in May and July. From a fundamental point of view we believe that there will be good support near 78 cents and solid support between 76 and 78, which also coincides with technical support levels.
Speculators, who had liquidated most of their net long position in January, have since rebuilt it to over 5 million bales during the recent rally. In doing so, they are once again providing some much needed liquidity for trade shorts to offset their positions against.
Wednesday's USDA report did not contain any big surprises, but it confirmed that the supply situation in current crop is not only extremely tight, but seems to be getting tighter, with the projected foreign production gap now estimated at 22.36 million bales, which is more than 4.5 million bales higher than the previous record. The seasonal gap between global production (102.24 mio bales) and global consumption (115.70 mio bales) now amounts to 13.46 million bales and with consumption still trending higher it will probably take a 15% increase in global output next year just to keep stocks from falling further.
While cotton's supply and demand numbers will certainly provide the base from which to project next season's prices, there are some outside influences that may make their presence felt in the not too distant future. One of these forces on our radar screen is a potential sovereign debt crisis, which could prick the bond market bubble and have far reaching consequences for all markets. Let's therefore examine this issue in more detail.
After the private sector credit bubble imploded in most western economies, governments quickly stepped in and shifted a lot of private debt over to the public sector. In addition to that they engaged in a number of spending programs to keep the economy from collapsing. These reflation efforts have not yet shown the desired results, as banks have been reluctant to lend to a struggling economy. Due to this current lack in the 'velocity of money' (the speed at which money turns over in the economy) many analysts have concluded that inflation is not something we should be too worried about.
While there is some truth to that logic, there is another way inflation can come into existence. Severe inflation or even hyperinflation can occur when a country's bond market collapses. With the US now running 2 trillion dollar budget deficits year after year, Europe having budget holes of similar proportions and individual states and municipalities adding hundreds of billions in red numbers, there comes a point at which these sovereign nations are no longer able to fund themselves. At that point the bond market starts to break and governments are forced to either print money or to default on their obligations. As interest rates rise as a result of this, they lead to higher debt servicing at a time the economy can ill afford it, making even more money printing necessary and then a vicious cycle ensues from which there is no escape. Once investors catch on to the fact that their currency is being debased, they start to buy anything tangible in order to store the value of their savings outside of currency.
We believe that we are at the cusp of such a funding crisis. Ironically this may happen at a time when financial advisors are telling their clients to put their savings into "safe haven" bond investments at virtually no return. It reminds us of the tech and the real estate bubbles in recent years and we feel that the herd is once again running towards such a cliff. If the above described scenario were to unfold, it would be very bullish for commodity prices in the long run, at least in nominal terms. In real terms it may be a different story as western economies would be faced with yet another, possibly much more severe financial crisis.
So where do we go from here? The ongoing correction seems to have further to go, but we expect strong trade support to emerge in the 76-78 cents range. There is an outside chance that the correction may carry further than that if some of the recently established spec longs are forced into liquidation, similar to what we have seen in January. However, this time around such a washout would probably be very short-lived, since the trade still needs to cover a substantial amount of shorts over the next three months. We believe that once this correction is over, another explosive rally is still on the cards.
The longer term picture remains somewhat uncertain at this point, but we currently favour a neutral to slightly bullish outlook given the large output gap, the low stock levels and potentially higher inflation down the road.
Best Regards
