Cotton market experiences some erratic up & down sessions

June 05, 2009 - United States Of America

NY futures moved higher this week, with July gaining 265 points to close at 56.88 cents and December rallying 298 points to close at 61.09 cents.

The cotton market experienced some erratic up and down sessions this week, as it seemed to be torn between support stemming from outside markets and pressure emanating from a growing certified stock ahead of the notice period.

A sharply weaker dollar and a rally in the commodity complex allowed the cotton market to ride along early in the week. Looking at open interest and spec/hedge figures, it seems that the bounce was primarily a function of short-covering by the trade combined with a lack of selling, at least until we reached higher grounds. Although there were some new spec long positions established since early March, it has certainly not been of the same proportion as we have seen in other commodities, but that may be yet to come.

Once again physical prices resisted following the futures market higher to the same extent and this caused this latest rally attempt to stall as July approached 59 cents. Also, the fact that the certified stock continues to grow rapidly, measuring now over 350'000 bales including the "under review" category, did not help the bulls' cause at this juncture. However, as we have tried to point out last week, the certified stock issue can be solved in two ways.

Either a taker is attracted by a cheap price, or he may take it based on a wide enough difference between July and December. As expected we have seen the July/Dec spread widen further this week and we are slowly but surely approaching a level at which takers may step forward. We believe that a spread of at least 450 points or more is needed to see this scenario play out.

We have talked repeatedly about the importance of the US dollar when it comes to forecasting commodity prices or any other asset class for that matter. If the currency in which such assets are denominated in gets debased, then the nominal price of these assets is almost certain to go up. History is replete with examples of what happens when currencies lose their footing; the most prominent is probably the "Weimar Republic" episode that unfolded in Germany in the early 1920's, which led to hyperinflation and ultimately the demise of the Reichsmark.

John Maynard Keynes described the situation back then as follows: ".belligerent governments, unable, or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." This sounds eerily familiar to the situation we are currently in, except that we seem to already have exhausted the option to secure more loans and are unable to tax an economy that is flat on its back.

It is more than a bit ironic when the Treasury Secretary of a nation that used to be the "Beacon for Capitalism" has to go hat-in-hand to its "Socialist Lender", trying to reassure the biggest foreign owner of US debt that everything is just fine, only to be laughed at by the student audience he was addressing. According to Reuters, Treasury Secretary Geithner drew loud laughter from Peking University students after he commented that "Chinese assets are very safe".

This seems to signal that the 'con game' may finally be up and that it will become increasingly difficult to secure the funding for the massive deficits that the US government, as well as the financial and private sector, has committed to. One of the main problems is that 70% of US GDP is based on consumption and in order to avoid massive contraction, this consumption level needs to be sustained. With private and business consumption dropping, the government has stepped in to fill the gap, but this does not solve the structural problems that exist.

In order to have the right to consume, one must produce. This is what the US economy used to do, but over the last two decades it somehow convinced itself that it would just let other nations produce, thereby creating large annual trade deficits, while it would 'settle' these deficits with IOU's (Treasury and Agency Securities). Sooner or later this had to lead to a credibility issue and that is where we stand today. Unfortunately there is no quick fix in sight because these structural imbalances need years to be corrected and this leaves a further pumping up of an already massive debt bubble as the only remedy right now. The alternative would be an immediate collapse.

The reason the US dollar has not shown more ill-effects from this policy so far is that other economies have engaged in similar strategies, which have been masking the problem. However, these competitive devaluations are starting to show side effects, with the main one being the threat of high or even hyper inflation down the road and this in turn is leading to an appreciation of commodity prices. Picture it this way - if the whole world engages in printing money, then sooner or later an ever increasing pool of money will chase a finite amount of resources and this has to result in higher prices.

We believe that the investment world has started to realize that holding cash in an inflationary environment doesn't make sense and we are therefore seeing a move back into equities - particularly foreign equities - as well as commodities. This will by no means be a linear move up, but over time we believe that all nominal prices of commodities will be substantially higher on the account of a depreciating dollar alone, irrespective of the individual supply/demand scenarios.

So where do we go from here? In the short-term the July liquidation will take center stage and in this regard it will be interesting to see how this growing certified stock will be dealt with. If the July/Dec spread keeps widening out and offers full carry, then it won't be as relevant where the outright price level is and we could see a taker even if the futures market was priced too high in comparison to cash prices.

While the initial rally to 60 cents was sponsored by spec short-covering, it is now the trade shorts that have begun to buy in their positions. The latest CFTC report showed the trade still 9.3 million bales net short, so there is a lot of potential buying power pent up in this position. We do indeed expect that the trade will be a net buyer of futures over the summer months as old crop basis-long positions are being sold to mills. Since speculators are not expected to sell commodities in a major way given the outlook for inflation and a weaker dollar, we need to ask ourselves where potential new shorts are going to come from.

Last week we thought that the market would give us another shot at prices in the low 50's, but after what happened in the outside markets this week we are not so sure about that anymore.