Market Comments – June 21, 2018

NY futures crashed this week, as December declined 867 points to close at 84.29 cents.

The market dropped just as fast as it had moved up, falling nearly 900 points in just three sessions, before trade support finally started to show up again. Prices were already drifting lower due to a lack of new buying and weakening technical signals, but when President Trump escalated the US-China trade war by threatening with additional tariffs, the market caved in.

Typically a steep drop like this is associated with substantial liquidation, as longs exit and shorts cover at lower levels. Even though total open interest declined by about 43k since last Thursday, going from 309k to 266k, most of it was tied to the anticipated liquidation of the July contract, where open interest dropped by 33k, from 39k to just 6k as of this morning.

However, open positions in new crop, that is to say December and later months, changed relatively little during this big decline. New crop open interest topped out at a record 269.9k contracts or 26.99 million bales on June 14, when December had closed at 92.96 cents. It has since dropped by just 10k to 259.9k contracts, or 25.99 million bales.

This means that even though new crop futures traded 176k contracts over the last four sessions, open interest was down by only10k, which corresponds to less than 4% of open interest. This indicates that there may have been a lot of churning of positions, but relatively little liquidation.

There were certainly some sell-stops hit when the market dropped through last week’s low of 88.40, but while some traders may have exited their positions, they either bought them back at a lower level and/or new traders came in to buy the market. Likewise many trade shorts seemed to have pulled or lowered their buy scales, thereby staying in most of their shorts.

Tomorrow’s CFTC Commitment of Traders report, which also includes options, should give us a better read on how spec and trade positions have changed during this decline. While we expect to see a drop in the spec net long and trade net short positions, specs and the trade may simply have swapped some or their respective outright longs and shorts.

Last week’s US export sales were a mixed bag, depending on the marketing year. While current crop saw across the board cancellations of 175,600 running bales in 15 different markets, which after new sales of 63,000 running bales resulted in a net reduction of 112,600 running bales, there were 341,400 running bales added for the coming season and an additional 73,800 running bales for the 2019/20-season. Total net new sales for all three seasons therefore amounted to an impressive 302,600 running bales.

Total commitments for the current season have dropped back to 17.4 million statistical bales, of which 13.7 million bales have so far been exported. Meanwhile sales for the next marketing year have risen to 5.5 million statistical bales, whereas commitments for the 2019/20-season are at just under 1.1 million statistical bales.

China singlehandedly accounted for the entire increase in export sales last week, taking 334,700 running bales across all three marketing years. This makes sense, since most other markets refused to buy cotton at last week’s elevated price level, unless they booked sales “on-call”. However, since these sales to China were made before the latest tariff announcement, we don’t know whether they will ultimately be honored.

It remains to be seen whether these announced tariffs will actually be implemented on July 6, or whether a full-blown trade war can still be averted. If these tariffs become reality, it will likely lead to some trade flow and supply chain disruptions, which might impact economic growth. It could also lead to higher inflation in the US, as some imports from China will have to be replaced with more pricey ones from other origins.

However, as far as cotton is concerned, we need to wait and see whether the impact is going to be as significant as some traders fear. China will probably still have to import more cotton over the coming years, even from the US. Let’s not forget that cotton has never been allowed to flow freely into China, as there have been tariffs of up to 40% in place for many years, with some exceptions, like the WTO and processing quotas. This season and last China imported just a little over 5 million bales each.

Initially China will try to buy more cotton from origins like Australia, West Africa and Brazil, but this will spike the basis in these places and we sooner or later expect China (perhaps the government/Reserve itself) to buy attractively priced US cotton again. In other words, the cotton world will learn to adapt to these changed circumstances and in the long term the price of cotton will be governed by global supply and demand, not by a trade dispute (although the dispute might impact the demand side of the equation to some degree).

So where do we go from here? The fact that open interest has remained so stubbornly high during this break could mean two things: 1) Either massive spec net long liquidation still lies ahead of us, which could force the market substantially lower from here, or 2) Specs as well as outright trade longs are giving the market a lot more rope than we thought, which could eventually swing the pendulum back the other way, as fixations and trade shorts begin to pay up. There are currently 14.13 million bales in unfixed on-call sales on the books for December onwards!

At this point we favor the second scenario, because over last two sessions trading volume has dropped considerably, which means that downside momentum is weakening. Furthermore, fundamentals remain supportive, apart from the trade dispute. The US crop has been struggling during this planting season and needs to prove itself in the months ahead, while the supply pipeline will be about as tight as we have ever seen it at the end of summer. Also, we would not be surprised to see a taker of July at these levels.

It’s a tough call at the moment, but if most of the speculators don’t bail out, trade shorts will once again be faced with the same liquidity issue that has forced prices into the mid-90s. 

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