Market Comments – February 11, 2016

NY futures dropped to new contract lows this week, as March lost another 181 points to close at 58.42 cents.
The cotton market fell to its lowest level since January 2015, as heightened fears of a global financial meltdown and a deteriorating chart picture continued to depress values. Not even another excellent US export sales report was able to halt the slide!
March options expiration played a significant role in this week’s selloff as well, as a large amount of short put options were caught by this falling market, which added to the selling pressure as traders scrambled out of positions. The March 60 put alone had over 9,000 contracts open when the market broke below the 60 cents level, which added thousands of new 'delta' long positions do defend against.

Stock and commodity markets around the globe came under further pressure this week, while gold and treasury bonds rallied, which speaks to the fear and panic that currently prevails in the world’s financial markets. With oil and equity prices falling, the non-performance risk has increased substantially, as the spike in credit default swaps attests to. There have already been some casualties in the energy and emerging market sector, but this is probably just the tip of the iceberg!
The problem the world is facing today is one of too much debt and leverage. Since the beginning of the century global public and private debt has risen from roughly 87 trillion to around 206 trillion dollars. Instead of paying down debt after the 2008 financial crisis, the world has taken on some 60 trillion dollars more debt in order to keep asset bubbles from imploding.
But this game of leveraging has its limits as it takes an ever-increasing amount of debt to generate a dollar of real economic growth. As more and more companies in the energy and emerging market space become unable to service their debt, the financial world will face deleveraging. This in turn has dire consequences for banks and bondholders, as debt will have to be restructured and/or written off. Central bankers will of course go all in and try to offset these forces for the umpteenth time, but listening to Fed Chairwoman Janet Yellen testify before Congress today, it became obvious that they don’t have many sensible options left.
As if the macro environment wasn’t bad enough for cotton, the USDA added to the bearish mood with its latest Supply/Demand report. The most damaging numbers were the reduction in US exports from 10.0 to 9.5 million bales and a 1.3 million bales drop in global mill use, from 110.9 to 109.6 million bales. While we agree that mill use needed to be lowered, and that it is probably still way too high, we were missing an accompanying cut in global production.
The USDA took world production down by just 0.2 million bales, from 101.6 to 101.4 million bales, which is still 4.1 million bales more than Cotlook’s 97.3 million bales. Nevertheless, as we have pointed out before, both the USDA and Cotlook arrive at similar seasonal production deficits of 8.2 and 8.3 million bales, respectively.
What we find contradictory in the USDA’s numbers is that they continue to project a rather large seasonal production gap in the ROW, but at the same time lower US exports, which makes no sense to us. Based on the USDA’s own estimate, countries outside the US and China are going to have a 9.4 million bales production shortfall this season. Since the USDA still expects China to import 5.0 million bales, the statistical hole increases to 14.4 million bales. There are only three potential sources available to address this shortfall, namely a) US exports, b) ROW inventories and c) Chinese exports.
Since ROW inventories were relatively tight last summer, especially in qualities that mills desire, and Chinese exports still seem a long way off, US exports remain the most obvious source to fill the gap. This is why we don’t agree with the USDA reducing its US export estimate, which is like removing a few more chairs from a game of ‘Musical Chairs’. In other words, the USDA’s own statistics suggest that there won’t be enough cotton to go around in the ROW, which is why every available bale of US exports will needed in order to meet demand before new crop arrives. We therefore stick with our 10+ million bales export forecast!
US export sales for the week ending February 4 surpassed expectations for a third week in a row, as a total of 294,500 running bales of Upland and Pima were sold for both marketing years combined. Once again there was broad participation with 20 different markets on the buyers list. Total commitments for the current season now amount to 6.5 million statistical bales, with shipments at 3.4 million bales. Sales for the 2016/17-season have reached slightly more than 0.9 million statistical bales at this point.
So where do we go from here? Financial markets are in disarray and it is difficult to predict how it will all play out, but deleveraging, overcapacity and defaults will keep pressuring equity and commodity markets, although money printing and currency shifts (dollar weakness) have the potential to trigger sharp countertrend rallies. Options, especially at the current low volatility level, are probably the smartest way for cotton traders to operate in this uncertain environment.
Despite all the doom and gloom in the financial world we feel that there is a good chance for a rebound in the cotton market, for the following reasons:
1) The end of the index fund roll period and tomorrow’s March options expiration should take some of the selling pressure off.
2) Momentum indicators (RSI, Stochastic and MACD) are in deeply oversold territory.
3) There is a lack of certified cotton and replacement values are above the current price level. The futures market seems to be overextended to the downside in relation to cash prices.
4) The March/May spread has started to narrow again.


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