NY futures dropped this week, with May falling 886 points to close at 192.12 cents, while December gave up 784 points to close at 120.96 cents.
Trading activity in the global financial markets was overshadowed by the catastrophe in Japan this week. The initial reaction by traders was a “flight to safety”, resulting in deleveraging of positions similar to what we saw during the financial crisis of 2008, although not quite to the same extent.
While the market was more or less able to gauge the damage caused by the earthquake and tsunami, it was much more difficult to assess the potential impact of a nuclear meltdown. However, over the last couple of days an increasing number of traders seemed to subscribe to the view of some prominent scientists who stated that even the worst-case scenario in Fukushima would primarily have local rather than global consequences.
The economic fallout from this disaster will probably come in the form of inflation! Just as the world is approaching ‘peak oil’, which refers to the daily production capacity of crude oil, the most prominent alternative energy source is suffering a severe setback. Germany has already taken 7 of its oldest nuclear power plants off the grid and a number of other countries are discussing similar measures. Nuclear power as an energy source will not disappear, but it will become much more difficult to expand or even maintain it. Oil and natural gas are the obvious choices to fill any gaps there might be – at a price of course – and this will likely translate into higher inflation.
The second problem from a macro point of view is that Japan is the second largest holder of US treasuries, having owned 886 billion dollars in bonds at the end of January. Japan will need a lot of money to rebuild its damaged areas and it is therefore possible that some of this money will be repatriated. At a minimum Japan is likely to buy fewer additional US bonds in the future, which means it will become more difficult for the US to fund its 1.7 trillion dollar annual fiscal deficit. The Fed will either have to print even more money than it already does or interest rates will have to rise in order to attract bidders, both of which are inflationary.
After traders were dumping stocks and commodities earlier in the week, they have since started to buy them back again with a vengeance. Corn futures serve as a good example of the frenzy and volatility we saw in the market this week. On Tuesday there were nearly 100’000 May corn contracts offered at limit down, while today over 130’000 contracts were bid at limit up. This clearly demonstrates the markets’ irrational behavior at the moment, as hoards of traders are stampeding blindly from one direction to another.
Cotton futures are no exception, as they have been swept up by this wave of alternating limit moves as well. Contrary to corn, spec participation is a lot lower in the cotton market at the moment, which is not necessarily a good thing though. The lack of liquidity can lead to exacerbated moves in both directions as we have seen, although our greatest worry is still in regards to the relatively large trade net short position that needs to be bought back. Spec selling in reaction to the Japan disaster as well as the upcoming index fund roll period may provide the market with temporary bursts of liquidity, but beyond that it becomes difficult for the remaining trade shorts to find enough willing sellers without forcing the price higher.
As of last Friday there were still around 5.2 million bales in unfixed on-calls sales on May (1.9 million bales) and July (3.3 million bales). Although that was 0.5 million bales less than the week before, there still remains a lot to be done and the clock is ticking.
So where do we go from here? Old crop futures will probably remain quite volatile and unpredictable, although there seems to be less fear of a major blow off. Resistance to these high prices has been growing and today’s US export sales report contained cancellations of over 90’000 bales in ten different markets, with China and Turkey leading the way. Some of this freed up US cotton may find its way to the certified stock, thereby helping to keep the market in check. In other words, May and July shorts don’t look quite as defenseless as they did a few weeks back and there are still 6.6 million bales in unshipped Upland commitments that could either be bought back or swapped out for other growths in case NY futures provided an incentive by exploding to the upside.
We therefore feel that the market will most likely trade in a volatile sideways range over the coming weeks, being well supported by trade short-covering on dips, while running into plenty of resistance from both trade and specs selling on rallies. As far as new crop is concerned, we still like December from the long side at around 120 cents for reasons explained in our previous letter.
Best Regards
