The market certainly has a different feel to it since hitting rock bottom early last week. The downside momentum is gone as specs are now buying the dips rather then selling rallies and the trade seems to have sold most of what it needed to against these large loan redemptions. There may still be some residual selling left to be done by the trade, but by and large the ceiling that the AWP vs. futures spread provided all season long no longer exists.
We believe that the market is currently in the process of forming a major bottom, as the 22.5 mio bales of spec and trade shorts have no reason to add to their respective positions. Quite to the contrary, the shift in momentum has already led to some spec short covering, while the trade should soon turn into a net buyer of futures as it sells its basis-long position overseas.
Reversing this downtrend is a process that will take time, but as the technical picture improves and moving averages cross over, it should eventually prompt some decent short-covering by the 9.8 mio bales of outright spec shorts. This in turn could invite hedge funds and other spec longs to join the rally.
The trade may initially sell into strength, but in reality it does not have that many bullets left to spend. Without much new crop cotton trading yet, the trade will find it difficult to justify additional futures shorts and will probably remain on the sidelines.
If a sharp rally were to occur, traders could even be forced to buy back some of their existing shorts, since a 10 mio bales net futures short generates US$ 50.0 million in margin calls for every cent the market goes up. And as we have seen in 2003, the trade does not have unlimited funds to play this big a game.
Also, let's not forget that there is a huge open interest in call options, which at the moment has a relatively small 'delta' exposure. But these short calls represent a potential liability in a rising market as the writers of these options would be forced to cover their exposure by buying futures.
In summary, we believe that the market has limited downside from here. The most likely scenario is that of a continued sideways trend, although the odds for a breakout to the upside are certainly increasing with every week of good export sales.