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Remarkable strength in NY cotton market
20
Aug '11
NY futures rallied sharply this week, with December advancing 1043 points to close at 106.95 cents. The initial stage of this potent rally was fueled by trade short covering, after traders used last week's dip to reduce their net short exposure.

According to the latest CFTC report, the trade had cut its net short position from 9.2 million bales to 8.6 million bales as of August 9, and judging by the decline in December open interest, which dropped by about 9'000 contracts between July 28 and August 16, it continued to do so this week. However, yesterday it was spec buying that started to take over the show based on an improved technical picture, with open interest finally starting to increase by 3'473 contracts.

From a technical perspective, there were several developments that have encouraged speculators to approach the cotton market from the long side recently. Not only did the market penetrate through a downtrend line that started at 140.90 cents in early June, but in doing so it has been forming a "double bottom" reversal pattern. In addition to that we've had a crossover of the 7-day over the 21-day EMA (exponential moving average) yesterday, which is often used as an entry point for technical traders. This may explain why the cotton market was able to shrug off today's horrendous performance in many of the outside markets, with global stocks caving in again and a number of commodities, such as oil and the grain complex, coming under heavy pressure.

What we don't like about this recent rally is that it happened in relatively low volume and with open interest declining, with the exception of yesterday, when volume finally rose to nearly 20'000 contracts and open interest jumped. In order to have a sustained rally, we need to see both of these measures expand. At the moment the jury is still out as to whether the market will be able to transition into a bullish pattern or not, because it has yet to take out the August 2nd high of 108.62 cents. If the market fails to do so over the next few sessions, any upside momentum is likely to going to fizzle and instead of beginning a new leg up, we may simply transition into a sideways range, which would more accurately reflect what we see in the physical market at the moment.

Although the physical market has improved somewhat and mills, who have been sitting on their hands for quite some time, will eventually need to step in and buy additional supplies, they will do so without any great sense of urgency. The way crops around the globe have been developing up to this point, there should be enough cotton available to accommodate the current level of demand. What is getting traders a bit nervous is the quality aspect, especially in the US, where a high percentage of the crop has already been committed. Texas, which traditionally produces a lot of the US high grades for export, is having a tough year, with its crop potential being slashed in half and heat stress raising serious concerns regarding the quality of the cotton that has survived. Other parts of the cotton belt may experience some quality problems as well, since some fields have matured faster than normal due to the excessive heat. Also, a lot will depend on what kind of weather we'll get at harvest. According to one prominent weather forecaster there is an 80% chance for an earlier and wetter than normal fall in the Northern Hemisphere, which could make things interesting.

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