Current cotton market reminds game of 'musical chairs'

18 Sep '10

6 min read

This tends to lead to an imbalance between market-driven longs and shorts; in this case the 8.4 million bales in spec longs and the 15.3 million trade shorts. While that is no problem in a neutral or bearish market environment, in a bull market it tends to exacerbate moves to the upside. In recent years we witnessed such extended moves in several markets, most notably grains, sugar and crude oil, and now it seems to be cotton's turn.

We feel that trade shorts currently have a tough time managing their sizeable net short position in futures. We estimate that the trade so far had to come up with some 1.3 billion dollars in margin money since July 20. Since there is hardly any inventory available as collateral, we imagine that banks are quite reluctant to extend additional credit to traders at this point.

We therefore have a market in which the shorts are forced to play defense, yet there are not too many traders willing to take the other side, since speculators prefer to ride this uptrend for as long as it lasts, while members of the trade are handicapped by cash constraints.

We believe that the relative strength we are seeing in December and March compared to the back of the board has a lot to do with this tight cash scenario. Although there is certainly a fundamental and technical justification for this bull market, if statistical tightness were the main driver, then the July contract would not be limping behind like it currently is. In other words, if there are fundamental reasons for December to trade beyond 95 cents, then July looks like a steal to us at 92.50 cents.

Once the crop is in, we believe that the inversion that exists within current crop futures will begin to reverse itself. We have already seen the October contract fall below December after it had traded at substantial premium several weeks ago and the Dec/March spread has started to reverse as well. Merchants will then once again have the opportunity to use certified stock to force carry back into the market. Regardless of the directional trend of the market, we believe that it does not make sense for March to trade at a 200-point premium to July, because it will be towards the end of the season when pipeline stocks are going to be the tightest.

So where do we go from here? Looking at the chart the market has now eclipsed all previous highs on the continuation chart going back to 1995 and the next upside target is the all-time high of 117 cents. So from a technical point of view there is not much in the way of higher prices at the moment. As we have explained above, the shorts are quite defenseless at this point due to cash constraints and may increasingly be forced to buy protection as the market moves higher.

All these factors are combining to fuel this bull market and have actually become self-reinforcing. What could possibly stop this runaway market? Maybe the harvest will bring about a different mindset among traders and we may also see some demand rationing take hold. However, we wonder whether these factors will weigh in soon enough to prevent a dreaded melt-up in the futures market.

Plexus Cotton Limited

More Textiles News - United States Of America...