Market Comments – May 31, 2018

NY futures exploded to the upside during this holiday-shortened week, with July rallying 569 points to close at 93.15 cents. 

It took just three sessions for the July contract to rally from an intraday low of 87.15 last Friday to an intraday high of 96.40 cents on Tuesday, for a gain of 925 points. For December the low-to-high move during these three sessions amounted to 838 points, as it shot all the way up to 93.73 cents. The market has cooled off a bit since posting these new contract highs, but remains well supported for now.

Trade shorts have simply been overrun by an onslaught of speculative buying this week, as evidenced by the sharp rise in open interest. Over the last four sessions total open interest in futures has gone up by another 12,007 contracts, or 1.2 million bales, from 30.08 to 31.28 million bales. While July O.I. has seen some liquidation, dropping from 11.87 to 10.92 million bales, December continues to attract new spec money, as its O.I. has gone from 13.99 to 15.66 million bales.

Never before have we seen so many futures open at the end of May! The current 31.28 million bales are nearly 4 million bales ahead of the second highest open interest at the end of May, which dates back to 2008, when there were 27.34 million bales open. The 10-year average is at just 19.53 million bales for this time of the year. The highest open interest for any date was set on January 25, 2018, when it reached 32.07 million bales.

The Chinese futures market continued strong as well this week, as the most actively traded January contract was up another 1,115 yuan/ton since last Thursday, to 18,805 yuan/ton, which at the current exchange rate of 6.41 amounts to 133 cents/lb. Open interest in the Chinese futures market reached another record today, as 1,355,586 contracts (of 5 tons each) remained open. This converts to around 29.89 million bales, or nearly the same open interest as we have on ICE. 

One issue that is often overlooked is that of margin calls. The latest CFTC report showed that the trade had 26.82 million bales in outright shorts (19.78 million net shorts). This means that when the market moves up 569 points in a week and the exchange raises the margin requirement by an extra 100 points, these trade shorts suddenly have to cough up an additional USD 33.45 per bale, which on a 26.82 million short position calculates to nearly USD 900 million. 

The problem is that a fairly large portion of these trade shorts are either against the 16.4 million bales in unfixed on-call sales and/or cotton that has just been planted or not been planted at all yet (Australia/West Texas for example). In other words, a lot of these trade shorts don’t have any collateral against them. Crops could still fail and/or buyers might walk away from an on-call contract. There were definitely some bullish strategies executed to safeguard against further margin calls over the past few sessions.

We also heard that some ‘accumulator’ buy strategies were invalidated this week when the market traded above the ‘knock out’ level. In short, this means that wannabe buyers, who were trying to accumulate longs via these structured products, were suddenly left unprotected when the market moved outside the anticipated range, forcing them to re-hedge at a higher level. 

We have seen a perfect ‘bullish storm’ lately, with massive amounts of new spec money coming in, mills being trapped with unfixed on-call sales, a sold out US market, strong demand, potentially higher imports by China next season, weather issues in the US/China, and trade shorts being forced into bullish options strategies, often against their will.

At least at the moment this doesn’t look like just another flash-in-the-pan short squeeze in the expiring spot month, but potentially something structurally bullish and longer lasting. We say this because it is new crop that has been garnering most of the attention, both in the US as well as China. 

Unlike last year, when they were liquidating longs at this point in time, speculators are looking beyond the July contract and are moving their longs into December, which already has an open interest of 15.66 million bales. Chinese futures are sending similar signals, as the price for January delivery is trading at a vast premium over nearby futures. While the ZCE July contract closed at 123.38 cents/lb, the ZCE January contract settled at 133.07 cents/lb today.

So where do we go from here? The market’s narrative seems to be that while some July shorts might still get squeezed, this isn’t really about July anymore, but rather a shift towards a more bullish market environment in 2019. China will eventually run out of reserve stocks and is therefore expected to increase its imports considerably. Combine this with some problems on the production side, strong downstream demand and an inflationary outlook, and we have the pieces to a bullish puzzle.

It’s the market’s job to prove this thesis wrong, but for now speculators on both sides of the globe are buying into it. The spec net long position is probably at a record by now at an estimated 13.0-13.5 million bales and while it may start to look like a bubble, it’s still anybody’s guess as to how long it will last and what will ultimately prick it. Technical exhaustion, improving crops, demand destruction, trade wars or an economic downturn come to mind, but at the moment none of these factors is in play yet, which means that the trade will likely be forced to play defense until something changes.


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