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Cotton market finally wake up
Aug '08
NY futures traded sharply lower this week, with December dropping 312 points to close at 71.38 cents, while March fell 350 points to close at 76.39 cents.

After nearly four weeks of dull trading, the cotton market finally woke up and embarked on a wild ride that saw it drop 673 points between Friday and Tuesday, before it claimed half of these losses back by the end of today's session. Average trading volume increased to about 24'000 futures during the sell-off, but it quickly subsided to just about half of that when the market rebounded over the last two sessions.

The fact that open interest dropped by over 6'000 contracts as the market sold off signaled that this move was lacking momentum, since we need to see a rise in both volume and open interest to validate an emerging trend. Rather than new short positions being put on, it was spec long liquidation that led to this break, with the trade waiting at lower levels to buy some of its shorts back. Once it became evident that this dip had uncovered a decent amount of physical business, trade buying became more aggressive while specs were done liquidating, which allowed the market to recover some of this lost ground.

Continued weakness in outside markets combined with a break of long-term technical support (70.73 cents in December) were the main reasons for this precipitous drop in the cotton market. The CRB index broke through a one-year uptrend line earlier this week, which prompted a flood of liquidation by the fund sector.

There was a strong rumor that at least one major fund was forced into liquidating its position, which may have exacerbated the sell-off. It was further reported that for the month of July hedge funds suffered their worst monthly performance in over 30 years. With credit getting tighter and with Congress watching their every move, many of these highly leveraged funds are being forced to retrench and they certainly don't pose the same threat to the market when it comes to fueling the commodity bubble as they did at the beginning of the year.

Many analysts predict a strengthening of the US dollar over the coming months, which as the story goes should weaken commodity prices. However, we believe that any perceived 'strength' in the US dollar should be seen in the context of 'all boats are sinking', whereas the US currency may temporarily sink a bit slower than some of its counterparts, such as the Euro or the British Pound. But when measured against tangibles, including commodities, we believe that any of these overly abundant paper currencies will continue to lose value, meaning that nominal prices of just about everything should continue to rise over time.

Next week the USDA will release its first detailed look at the 2008/09 season. Last month the USDA predicted a global production gap of 11.0 mio bales, which the market doesn't seem to believe, otherwise we would not be trading in the low 70's. Even if we take out the'loss' adjustment, the statistical gap remains unrealistically high at 8.0 mio bales.

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