Trade shorts are obviously still convinced that their massive net short position in New York is warranted and that it will sooner or later pay off. According to the latest CFTC report as of February 12, which included the fallout from March options expiration, the trade had increased its net short position by an additional 0.6 million bales to 16.1 million bales. On the other side index funds expanded their net long to 7.8 million bales, while speculators were 8.3 million bales net long.

The liquidation of the March contract continued in an orderly fashion this week and open interest was down to just 5’581 contracts before today’s session. With the March/May spread trading at more or less full carry, we don’t believe that the certified stock of 360’541 bales (including bales under review) will have any major market impact as we head into First Notice Day tomorrow. There were 1’040 notices issued this afternoon, all by Allenberg, with a plethora of takers receiving them.

Although the market seems to have found some equilibrium after having rallied nearly ten cents over the last six weeks, the huge open interest in May is warning us that this may just be the calm before another storm. As of this morning, open interest in May amounted to 137’530 contracts, which compares to 72’000 to 95’000 contracts at the same date in the previous three seasons.

Only twice before has a spot month seen higher open interest than now, namely in February 2008 and in September 2010, when open interest in the most active month topped out near 150’000 contracts. What followed in both instances were parabolic short-covering rallies, first the infamous cash squeeze of March 2008 and then the epic rally in late 2010/early 2011.

The lesson to be learned from these two events is that a short-covering rally in the futures market does not necessarily have to be justified by fundamentals. In 2010/11 the physical market was leading the way, while in 2008 it didn’t participate at all. Ironically, a bearish market outlook can actually contribute to the set-up for a short squeeze. If nearly everyone in the trade is convinced that prices can’t possibly go higher and the short grows to a ‘critical mass’, it may actually set the stage for a big upward move. All that’s needed is a trigger that sets a short-covering rally in motion.

So where do we go from here? As we have pointed out last week, the trade will either have to get out or roll out of its big short by the time July goes off the board in four months. Remember, there exists an imbalance between spec longs (8.3 million bales) and trade shorts (16.1 million bales), because index funds don’t really play the liquidation game and will simply roll their net long from one futures month to the next. This set-up puts the trade at a certain disadvantage vis-à-vis speculators.