Market Comments – April 21, 2016

NY futures made a big move this week, as July gained 316 points to close at 64.01 cents.
 
The market continued its impressive run and the July contract has now gained nearly 10 cents since making a spike low of 54.33 cents on February 29.
 
This week’s rally started on Sunday during the usually uneventful night session, when short covering that was seemingly linked to Chinese traders began to bid up prices in both Zhengzhou and ICE futures. In China the most actively traded September contract has gained 1,650 yuan/ton or more than 14% over the last four sessions alone!
 
When US traders woke up on Monday morning the July contract was already about 200 points higher and it managed to hold on to these gains in a heavy volume session that saw nearly 72,000 futures traded. From there the market has continued to push higher, with dips being eagerly pursued by either shorts or new longs waiting to enter the market.
 
While the May contract liquidated its remaining open interest fairly quickly to just 5,425 contracts as of this morning, July and December saw their open positions expand this week. July open interest amounted to 111,752 contracts as of this morning, an increase of 10,214 lots over the last five sessions, while December was at 58,105 contracts, up 4,893 lots since last Thursday.
 
Our guess is that while some spec shorts have covered their positions, there has also been some rotation, with new spec longs and trade shorts entering the market. This would explain why overall open interest remains relatively elevated in relation to the amount of cotton that is still up for sale in current crop.
 
The problem we see with July’s 11.2-million bale open interest is that for the next seven weeks there is relatively little liquidity on the long side, since Index Funds hold around 7.4 million bales of all the longs in July. These Index Fund longs will be inactive until it is time to roll into December, which will not be until June 7. Therefore, if spec and/or trade shorts in July decided to get out for whatever reason, we doubt that there will be enough longs willing to sell and/or new shorts coming into the market.
 
This sets the market up for a potential short squeeze, especially since there is no compelling reason for the trade to add additional July shorts at this point, while speculators typically don’t sell a bullish trend, but rather buy into it.

In our last report we commented on the recent change in the AWP calculation, which prompted merchants and growers to redeem about half of the 2.6 million bales that were still in the loan last Thursday. Hedge selling against these 1.3 million bales in redemptions forced the market to briefly dip towards 59 cents on Friday, but it has all been uphill from there.
 
Based on our calculation about 2.9 million bales of US cotton have yet to be sold at this point, taking into account all domestic needs and export commitments until October. Since there are just 1.3 million bales left in the loan, it follows that there are currently some 1.6 million bales held outside the loan in search of a home.
 
In an inverted market it does not make sense to hold on to inventory, especially when a lot of it consists of less desirable qualities, which means that we will probably see a push by merchants to offload this cotton as quickly as possible. In a cash market that is only reluctantly following the lead of the futures market, we might therefore see some basis pressure in medium and lower grades. Nevertheless, since this cotton is probably going to be sold rather quickly, it should translate into decent export sales and a tightening balance sheet and thereby solidify already bullish current crop fundamentals.
 
US exports for the week ending April 14 were about as expected, as 138,100 running bales of Upland and Pima cotton were sold for both marketing years combined. Buying interest was widespread with 18 markets participating, while shipments of 211,400 running bales went to 27 destinations. Total commitments for the current season have now reached 8.3 million statistical bales, of which 5.7 have so far been exported and 2.6 million bales remain open.

So where do we go from here? The futures market has rallied on short covering and new spec buying and it will be interesting to see what positions the CFTC report reflects tomorrow. If it shows that a considerable amount of shorts has yet to be covered, as we believe, we could see additional rallies in the weeks ahead, given the structural imbalance that exists between market driven longs and shorts, i.e. positions that are not related to index funds.
 
The biggest threat to the remaining shorts is probably the influx of new speculative money, which is evident across the commodity spectrum. With nearly 8 trillion dollars of sovereign bonds around the globe being penalised with negative interest, investors are increasingly forced to look elsewhere for a return and are therefore putting their money into stocks, real estate and commodities. We believe that the CRB index has bottomed on January 20 and is now in an upward trend, which combined with a friendly fundamental and technical picture for current crop cotton does not bode well for the shorts in July.

 

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