NY cotton futures reach their highest peak

30 Oct '10

6 min read

As we have learned over the past few years, macroeconomic developments and the resulting money flows have a greater impact on commodity prices these days than ever before. We have repeatedly talked about how a weakening US dollar can lead to higher nominal prices and in that regard we are getting increasingly worried about what we are currently seeing in the US bond market.

There is a lot of talk about more 'quantitative easing' by the Federal Reserve these days. What this means in a nutshell is that the Fed will create money out of thin air to purchase treasury bonds in order to keep interest rates low, which in turn is supposed to jumpstart the economy. Many of the so-called bond experts and gurus that are quoted in the financial media make it sound like the Fed has a choice in how much treasury debt it is going to buy. This is not entirely accurate! Gross Public Debt is now approaching 14 trillion dollars and keeps rising by around 2 trillion dollars a year. So far "the market", a large number of which consists of foreign Central Banks, has been absorbing this escalating debt issuance, often in an effort to keep their own currencies from appreciating too much against the US dollar.

However, there is a limit as to how much longer investors and foreign Central Bankers are able and/or willing to keep this game going. There will be a time, probably sooner rather than later, when the market will no longer absorb all this extra debt and it may not even be willing to roll existing debt forward.When that happens the Fed will have no other choice but to take on all the debt the market is not willing to underwrite. Imagine what would happen to the US dollar if the Fed had to monetize several trillion dollars of debt over the coming years!

It is no coincidence that the Fed is trying to convince investors that deflation is the problem, since it wants to keep them from leaving the bond market. Once the market fears inflation, it will no longer be as willing to hold on to bonds, especially at these lousy yields. However, with commodity prices rising sharply and global equity markets rebounding, it is becoming increasingly more difficult to keep investors in the bond market. In normal times we would see interest rates go up in order to attract investors, but with an economy and a housing market as fragile as they currently are, that won't be an option. This means that the Fed may have to step in as the buyer of last resort and monetize debt at unprecedented levels. The price to be paid for this folly is a further debasement of the US dollar, which in turn will translate into even higher nominal commodity prices over time.

So where do we go from here? Based on where physical prices are trading right now the December contract is more or less fairly valued. Forward pricing currently suggests that physical prices will gradually weaken as we head into the first and second quarter, but this would only make sense if demand destruction were to erase the seasonal production gap over the coming months. However, should demand prove to be more resilient than anticipated or if the Chinese Reserve came in to absorb a million tons or two into its stock, then the third quarter might turn into a rather explosive affair.

Plexus Cotton Limited

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