Market Comments – July 2, 2015

NY futures continued to advance this week, with December rallying 201 points to close at 67.39 cents.

The December contract made a strong technical move to the upside this week, piercing through two key resistance levels as defined by a ‘coil pattern’ and the upper end of a 9-month trading range. This chart action triggered a new wave of spec buying, propelling December to its highest close since last September.

Volume was impressive, reaching nearly 50’000 contracts when December broke through 67 cents on June 26 and then again two sessions later when the market reversed a selloff and closed nearly three cents above the low of the day. Open interest rose almost 20’000 contracts overall since early last week, of which over 15’000 were in December, which confirms that speculators established new longs while the trade added shorts. Open interest in December amounted to 158’854 contracts as of this morning, which is the third highest for this date after 2008 (166’701 contracts) and 2007 (159’653 contracts).

While the technical picture looks constructive at the moment, the same cannot be said of fundamentals. Physical prices have so far not followed the lead of the futures market, as mills are in no hurry to chase these prices in view of a subdued yarn market and cheaper polyester prices. However, merchants have been very active this week establishing sizeable basis-long positions, buying physical cotton in various origins such as India, East and West Africa, Brazil and the US, and then hedging it with bearish futures and/or options strategies. In India alone the CCI sold well over 900’000 local bales this week, of which a large portion went to international merchants.

In other words, we have a tug-of-war between bullish specs and a bearish trade. As we have explained last week, what makes the market dangerous at the moment is that speculators have the ability to throw large sums of money at the market, while the trade doesn’t really have the means to stop them. First of all there is very little tenderable cotton left at this point and merchants will have to wait for new crop supplies before being able to boost the certified stock to a threatening level. Even if the trade had more cotton at its disposal, it couldn’t throw it at the specs until the next notice period rolls around, which is still five long months from now.

This situation reminds us of an old saying by value investor Benjamin Graham, who explained that in the short run the market is like a voting machine, but in the long run it is like a weighing machine. In other words, while markets follow the laws of supply and demand over the long run, they can be swayed by rumors and money flows in the short term.

Some traders fear that the cotton marked could be swept up in a move similar to what we saw in March 2008, when hedge funds overwhelmed a cash-strapped trade and took the market hostage for a few weeks. We are not too worried about that, because the trade net short position amounted to just 8.3 million bales net last week, which is small compared to the 23.8 million bales in early 2008. Also, we are now in between crops and the trade should therefore have plenty of financing available to manage margin calls, allowing it to stay in its short position.

This week’s US acreage report came in at the lower end of expectations at 9.0 million acres, but thanks to a good moisture profile across the cotton belt we are likely to see fewer abandoned acres and we should also see above average yields. Crop conditions are currently among the best in the last decade and the potential for an above average crop therefore still exists. The same goes for India, where the monsoon has arrived more or less on schedule.

US export sales continued at a good clip last week, as commitments of Upland and Pima cotton rose by 143’200 running bales net. 88’400 running bales were for prompt shipment and 54’800 bales were for August onwards. There were still 19 markets participating, with Vietnam once again listed as the most active buyer. Shipment of 238’200 running bales maintained their strong pace and reduced the unshipped portion in the current marketing year to just 1.25 million running bales. Total sales for the season have risen to 11.6 million statistical bales, of which 10.3 million have so far been exported. It is now almost a certainty that the USDA will have to raise its current export estimate of 10.7 million!

The announcement that the Chinese government will auction off one million tons of its strategic reserve in July and August led to a short-lived selloff on Tuesday, although it mostly confirmed what the market had already anticipated. The auctions will contain a mix of bales from crop years 2011 (330k tons), 2012 (470k tons) and imported cotton (200k). The fact that there is more 2012 cotton in the mix doesn’t please buyers, because the quality from that season is considered inferior.

Also, a new twist in the Chinese reserve saga is that the government will only buy current crop cotton at 40% of auction sales, i.e. a maximum of 400’000 tons. In doing so the government is taking a first step to reduce its inventory burden, but this means that someone else will likely end up holding additional stocks, like the PCC in Xinjiang. Having a larger amount of unsold stocks floating around in the marketplace may therefore put pressure on local prices.

So where do we go from here? The story is quite simple at the moment – the specs are long and may go even longer, while the trade is standing its ground on the short side. The specs of course hope to incite a short-covering rally by the trade, which is often how these rallies get fueled, but we don’t sense any panic among the trade and therefore believe that the likelihood of such a short-covering rally is relatively small. This means that the specs may have to take the market higher on their own, which they may be able to do for a while, but sooner or later we expect the upside momentum to stall and the trend to reverse back down again. The current futures price implies a cash value for US high grades in the low-to-mid 80s landed Far East, which is nowhere near what mills are willing to pay. Therefore, unless there is a crop problem or a revival of demand, we consider the futures market as being overvalued.