NY futures have moved sharply higher since our last report two weeks ago, with December gaining no less than 1064 points during that period, closing today at 113.63 cents.

Before breaking out to the upside on Wednesday, the market had closed the previous 12 sessions in a very narrow band of just 335 points, between 102.99 cents and 106.34 cents, with open interest showing hardly any change at all. But just when everyone was getting used to a dull sideways trend, the market found a way to escape the boredom. Although some point to the recent floods in Pakistan and the rains in India as the cause for this rally, we believe that it was a wide variety of factors, both fundamental and technical, that led to this bullish move.

We have repeatedly talked about the lopsided position by the trade when it comes to US cotton, since merchants are short physicals as well as NY futures. Export sales of 7.0 million statistical bales (not counting sales with optional origins) and domestic mill requirements of 3.8 million bales add up to commitments of nearly 11 million bales, against which there were less than 3 million bales in beginning stocks as of August 1st. This means that it will take a while until new crop is sufficiently available to cover all these commitments and then there is the quality angle that may further complicate matters this season. West Texas is likely to produce a lot of ‘popcorn cotton’ due to heat stress, while the Mid-South and Southeast are exposed to very active tropical weather at the moment.

In addition to the physical short, the trade also has a substantial NY futures exposure, since it has sold a lot of contracts as hedges against long positions in foreign growths. The latest CFTC report showed the trade 9.0 million bales net short in futures and options, which leaves them vulnerable to a short squeeze. Even without a squeeze the trade will likely be a net buyer of futures over the coming months, as it will lift short hedges against sales of foreign growths.

Enquiries are definitely picking up, as mills are in the process of replenishing their inventories. Yarn prices have started to rebound as well and we are seeing some encouraging signs on the retail front. “Back-to-school” sales in the US were surprisingly strong despite the gloomy economic outlook, as sales at major chain stores rose 4.4% year-over-year in August. Furthermore, the International Council of Shopping Centers estimates that sales will rise 3.5% during the November and December holiday period, which accounts for about 40% of annual turnover. We suspect that cotton consumption at 113.93 million bales for the 2010/11-season and 115.18 million bales for the current season may be slightly understated and perhaps the market is starting to feel the same way.

The fact that the Chinese Reserve is, as of September 8, actively procuring cotton in an effort to restock its depleted inventory, is another important element of support for the market. The first procurement auction for 24’300 tons failed to attract any sellers, which is seen as a bullish sign by the market. The buying program by the Reserve is intended to run through March 31, 2012, and should provide decent support underneath the market. Although no quantitative limit has been set, we assume that the Reserve will try to replenish most of the 16.5 million bales it released into the market between May 2009 and October 2010. At a minimum we would expect this buffer stock to grow to around 3 months of domestic mill use, which would amount to roughly 11-12 million bales. This Reserve buying will feel like additional demand to the market over the coming months and should counteract any bearish forces stemming from a global production surplus this season.

While fundamentals created a solid base, it was chart-related buying that provided the fuel for this rally. The market had plenty of opportunities to sell off over the past few weeks, but instead it managed to linger not far below resistance at 109 cents and it was therefore just a matter of time before the market would try to take out this level again. While earlier attempts failed, the conditions seemed right this time, because the trade was either no longer willing or able to absorb renewed spec buying. Yesterdays move triggered new buy programs and as a result we saw heavy follow-through buying today, with volume estimated at nearly 30’000 futures.

So where do we go from here? Although fundamentals look somewhat supportive (trade short, Chinese Reserve buying, weather), this was clearly a spec-induced rally and it remains to be seen whether the current momentum can be sustained in order to extend the up move. This means that we need to see strong volume and rising open interest over the coming sessions. Failing to do so, the market will probably run out of steam and fall back to the breakout area. The specs of course hope that trade shorts will be forced to cover, which would provide additional fuel to the market. However, cash prices seem to resist this latest advance and it would probably take another weather event to scare the trade into chasing after prices. Also, the fact that October is starting to lose ground against December should be seen as a warning sign. Therefore, until proven otherwise, we shall treat this rally as an extension of the recent sideways trend rather than the beginning of a new bull market.

Best Regards