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Charming days for cotton market
26
Sep '09
NY futures were able to consolidate recent gains, with December advancing 63 points this week to close at 64.81 cents.

The cotton market made a strong statement today! Neither a weak stock market nor a dollar rally were able to stop cotton in its tracks, as it managed to shrug off a 100 points decline earlier in the session to close at the highest level since July 20.

There is a big difference to the last two times the market challenged the 65 cents level! Back in July and August the US crop still looked promising, but now there are a lot of unanswered questions regarding the size and quality of the US crop after large parts of the Mid-South and Southeast received way too much moisture in recent weeks. It will probably take another month or two before we have a clearer picture of what this crop looks like, but traders are certainly much more reluctant to add to their already considerable futures short position amidst all this uncertainty.

On the other hand we have trend-following speculators jumping back into the cotton market, with the conviction that "the third time's a charm" and that values will finally break above the 65 cents barrier. Since this latest rally started on August 27, daily trading volume has improved noticeably and open interest jumped from 123'335 to 146'248 contracts, which tells us that there has been a lot of momentum behind this move.

When we look at the latest CFTC report as of September 15, we can clearly see that speculators were driving this market north, while the trade continued to sell into strength. The net positions of the main players and the changes to the previous week look as follows:

Index Funds = 7.5 million bales net long (+ 0.1 million)
Speculators = 2.1 million bales net long (+ 1.3 million)
Trade = 9.6 million bales net short (+ 1.4 million)

As we have stressed repeatedly, the fact that Index Funds own such a large block of the net long position poses a problem, because it creates an imbalance between price sensitive longs and shorts. As long as there is no reason for shorts to cover their positions, nothing will happen, but when there is a scenario in which shorts want to get out (changed market outlook) or need to get out (margin calls), then who will be there to take their shorts from them? Speculators are only 2.1 million bales net long and they have an appetite for more longs in an uptrend like this. Index Funds, as we have learned, are driven by money flows and have no eyes for the market as such. They will not sell any of their positions until money flows reverse.

Due to the recent weather problems in the US we may have arrived at a point where the trade not only stops selling, but it may actually start buying call options or call spreads to protect its futures short position. Also, since new crop is not available in any volume, there is really not much to sell against at the moment and putting on more basis-longs in foreign growths may be risky since the weather problems in the US could cause the basis to weaken considerably.


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