NY futures traded lower this week, with December dropping 201 points to close 111.62 cents.
Although the market did not find enough follow-through buying to keep last week’s upside momentum going, it has so far managed to hold and consolidate recent gains. Volume tapered off considerably after 30’000 lots had changed hands last Thursday and even though overall open interest increased by 1813 contracts since then, December saw its open interest drop by 560 lots. In other words, we are not seeing the kind of action that’s needed to move the market higher at this point.
However, conditions in the physical market have definitely improved in recent weeks, with yarn values continuing to trend higher and mills apparently being able to work with replacement values of around 120 cents landed Far East at the moment. Also, the floods in Pakistan’s Sindh province have probably washed away some 1.5 million bales and impacted the quality of the cotton that survived, while persistent rains in India’s Northern Zone has also adversely affected output and quality, which is lending support to the market.
When we look at the Indian Subcontinent (India, Pakistan and Bangladesh) as a whole, we have production at 37.3 million statistical bales according to the latest USDA report, while consumption amounts to 34.5 million bales. Although Pakistan and Bangladesh have been importing cotton from a wide variety of origins in years past, we believe that they will lean heavier on India this season. Pakistan has already taken up some Indian high grades recently and will likely continue to do so over the coming months, while we suspect that Bangladesh may consider Indian spot cotton for financial reasons. If our assumption were correct, then Indian prices should remain well supported over the coming months.
About 80 percent of global cotton exports come from just 5 origins – the US (32%), India (15%), Australia (11%), the Central Asia (11%) and Brazil (10%). We don’t expect any of these growths to exert much pressure on prices in the near future. The US and India will likely encounter some bottlenecks and quality issues at the beginning of their harvest, with unsold stocks not likely to weigh on the market until some time in the first quarter, while Australia and Brazil are also quite well committed in current crop and next season’s supplies won’t be available before May/June shipment. Central Asia still has a lot of cotton for sale, but there are logistical limits as to how much they can bring to the market every month.
Therefore, we feel that over the next few months the amount of cotton that is being supplied to the market won’t overwhelm demand. Mills have run down their inventories and need to reload and then there is still the Chinese Reserve, who will act as a backstop, ready to sweep up attractive offers along the way.
Although there are some elements of support in the near term, we see no reason to become enthusiastic. The fact that US export sales were once again reduced by 170’600 running bales net last week is a troubling sign in the long run, because once the 4th quarter bottleneck is behind us, the US will have to find a home for its leftover bales, many of which will probably be of inferior quality. With traditional importers like China, Turkey or Mexico having bigger crops of their own this season, and with Australia and Brazil coming into the picture later in the season, it may not be an easy task for the US to dispose of its remaining cotton.
Another potential threat to the bullish case looms from Europe, where a sovereign debt crisis could trigger de-leveraging in commodity and stock markets, similar to what we saw happening in 2008. Instead of Lehman Brothers the domino will be Greece! The way this may unfold is that Greece leaves the Euro and goes back to its own currency, the Drachma. When that happens, Greek bonds denominated in Euro will be re-denominated in Drachma and bondholders will be forced to take a huge haircut via a devalued exchange rate. Greece may just be the first in a series of such spin-offs, with other peripheral nations likely to follow. Since undercapitalized and overleveraged financial institutions, such as banks, insurance companies and hedge funds, own a lot of these sovereign bonds, it would probably lead to another liquidity crisis.
There is simply way too much debt in the system, not just in Europe, but also in the US, Japan and many other economies. The market will not rest until this massive debt bubble is dealt with, which can only happen in the following three ways: 1) Strong economic growth to pay off the debt over time (not likely to happen!), 2) Massive defaults that purge the debt from the system but lead to depression for years to come (politically not acceptable!) or 3) Inflating the debt away by printing money (the most likely endgame!). In the interim we are probably faced with a hybrid of the second and third option, where defaults occur (Lehman, Greece) but are remedied by monetary intervention.
So where do we go from here? For the reasons explained above, we continue to see the market being wedged between decent support and formidable resistance, which argues for a continuation of the current sideways trend. However, we need to remain vigilant of potential forces that could trigger a breakout on either side, such as weather problems (bullish) or another financial crisis (bearish).
Best Regards
