NY futures rebounded this week, as May gained 99 points to close at 58.70 cents.
The CFTC spec/hedge report provided an explanation for the market’s recent selloff, as it revealed that speculators had sold a massive amount in the futures market during the week of February 3rd to February 9th, prompted by a breach of long-term support and fears of a global recession. Speculators large and small sold no less 2.8 million bales net during that week, which was the second largest volume of spec selling ever! In doing so, speculators turned their 1.3 million bales net long into a 1.5 million bales net short position.
Interestingly, outright spec longs cut their holdings by just 0.4 million bales, from 7.4 to 7.0 million bales. The selling pressure came almost entirely from new spec shorts, which increased their position by 2.4 million bales, from 6.1 to 8.5 million bales short. This was only the third time over the last ten years that outright spec shorts amassed a position of over 8.0 million bales. In May 2007 spec shorts got to 8.6 million bales and in January 2015 they reached a record 9.0 million bales, but in both cases the market rallied sharply over the following weeks as specs rushed to cover 5 to 6 million bales.
Will history repeat itself or is this time going to be different? We believe that speculators have turned increasingly negative on cotton as well as other Ag commodities, notably corn and soybeans, due to the global stock market rout and the gloomier outlook for economic growth. This is substantiated by the fact that speculators have basically tripled their outright short position from 2.9 to 8.5 million bales in the six weeks between December 29 and February 9, a period during which financial markets started to show considerable stress.
While speculators aggressively sold the market, the trade took advantage of these cheaper values and bought back 7.3 million bales since December 29, thereby reducing its net short from 11.6 to just 4.3 million bales. Although the mood among cotton traders seems to be quite subdued lately, the fact that the trade short dropped by that amount in just six weeks suggests that there has been a lot of business done. Mill fixations explain some this reduction in trade shorts, but they have only dropped by about 1.2 million bales since late December and therefore account for just a small portion of this trade activity in futures.
US export sales have amounted to around 1.1 million bales since the beginning of the year and tomorrow’s delayed export sales report should show another constructive number. Although the US has been forced into the role of residual supplier this season, the fact that many other origins are now well committed should make for strong US sales in the second and third quarter. We continue to be of the opinion that supplies are going to be tight over the next 6-8 months, despite somewhat softer demand. High grades will sell out first, but eventually the tightness will be felt across the entire quality spectrum.
The renewed inversion of the July/Dec spread seems to reflect this outlook. Most current crop supplies have already moved from growers to merchants and there is little need to sell additional May or July futures as a hedge against new physical longs. US loan cotton is a notable exception, as merchants will use rallies to lock in a favorable spread to the AWP, which is currently below 45 cents. Some of today’s selling near the highs was probably tied to this scenario.
However, in general it is fair to say that most of the trade selling from here on forward will occur in the December contract. Over the next few months most of the Northern Hemisphere will get planted and growers are going to look for price protection in the futures and/or options market. We should therefore see more selling in December relative to May and July, which should to feed the inversion going forward. Only a large carryout and/or certified stock would prevent this from happening, but this is not likely to be a deterrent this season.
So where do we go from here? Aggressive spec selling has forced the market from 65 to 58 cents since Christmas, followed by a slight rebound to 60 cents. A lot will now depend on how financial markets perform going forward, since the large spec short position is tied to a bearish macro view.
From a fundamental point of view cotton supplies in current crop are tight and will only get tighter as we head into the second and third quarter, which raises the odds for a short-covering rally at some point. Before that can happen the market will need some clarity in regards to China’s reserve cotton. Although a lot of the potentially bearish news has already been discounted, we could still see a kneejerk reaction once China announces its policy.
However, given the large spec short position and the tight physical market we like the July/Dec spread going forward, which has the potential to invert a lot more in our opinion.
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