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NY cotton futures on backfoot
May '09
NY futures sold off further this week, as July dropped 255 points to close at 54.23 cents and December gave up 193 points to close at 58.11 cents.

Until about two weeks ago the cotton market was in sync with the bullish trend of outside markets, but is has since taken on a mind of its own and traded lower, while most commodity and stock markets continue to move higher. However, cotton futures are still up by 30% since early March. Maybe cotton was just running a bit ahead of itself and simply needed to catch its breath.

There are both fundamental and technical reasons to explain the weakness we are currently experiencing in the futures market. Compared to physical prices the futures market went way too far when it rallied about 20 cents between early March and the middle of May, since prices paid by mills advanced by just about 12-13 cents. While the futures market sometimes takes on a life of its own, it sooner or later has to reconcile with the physical market, especially when we are headed into another delivery period.

With physical prices seemingly being capped by the abundance of supplies around the globe, particularly after China announced last week that it would auction off 7 million bales of its strategic reserves, it was almost impossible for July futures to maintain, let alone extend the lofty levels it had traded to.

At 60 cents the spot futures contract, which has a premium for high grades of about 350 points, was paying about the same as mill buyers overseas and this was attracting cotton to the board. In a little over a month the certified stock has grown by over 110'000 bales (including bales under review), from around 200'000 to 310'000 bales and it will probably continue to increase.

Another reason why merchants are adding certified stock is to force carrying charges back into the market. With only about half a million bales remaining in the government loan, the trade is currently carrying over 5 million bales of unsold inventory as a basis-long position and it therefore needs the spread between July and December to widen.

A couple of weeks ago the spread narrowed to as little as 165 points or 33 points per month, which was way short of what is needed to carry this inventory. By increasing the certified stock the trade tries to create leverage to get this spread back to about 450 or 500 points, which would allow it to roll its short futures position from July to December at full carry.

In order for the certified stock to become attractive to a taker, outside of having full carry in the spread, the July contract would probably have to drop to around 48-50 cents, provided physical prices don't move lower in the meantime. In other words, a potential taker will either need a full spread or a low enough cash value before committing to the certified stock.

From a technical point of view both July and December have now violated their uptrend line, volume has beenheavier on down days than on up days and open interest is contracting. It all adds up to a weakening market in search of support. July should find support between 52 and 53 cents, while the level for December is 57 cents. On the weekly chart the support area is at around 50-52 cents.

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