Plexus Cotton Limited reported that New York (NY) futures had a mixed performance this week, as July dropped another 239 points to close at 71.55 cents, while December was down just 32 points to close at 70.35 cents.
After losing around 24 percent of its value in just 22 sessions, averaging losses of 100 points per day, the cotton market seems to finally be regaining its footing.
We believe that the market’s plunge was caused by a combination of the following factors:
a) Grower hedging, mostly via bearish options strategies;
b) a large short put position by the trade, which led to a rapidly increasing delta long position in a falling market and forced traders to play defense;
c) A deteriorating chart picture, which invited spec selling, especially when the market broke through long-term support near 83 cents and
d) Money managers once again moving to a “risk off” position in commodities.
The above factors combined to a ‘perfect storm’ of selling, while buyers were nowhere to be seen, which created a vacuum underneath the market. However, once the market approached the 70 cents level, the equilibrium got restored, as sellers were either less inclined to sell or had no more reason to, while bottom pickers started to look for bargains.
Although there has been some out of the money put buying this week, growers are generally not chasing prices below 70 cents at the moment. The trade, which got caught on the wrong foot when the market fell through its short put position, has already taken most of the hit since there aren’t many puts left to defend against below 70 cents.
Short speculators, who got rewarded nicely by this selloff, are not likely to add to their shorts in an oversold market and are probably focusing on protecting their profits instead. Even the “risk off” trade may come to an end soon, as members of the Fed are already hinting at additional stimulus to combat the prevailing doomsday mood.
Cotton held up relatively well during this “Chicken Little” week, where the sky seemed to be falling on just about everything else. The fear factor is rising and fund managers are taking all kinds of bets off the table, parking their money in government bonds.
Today the 10-year US Treasury bond yield reached an all-time low of 1.5309% and German, French, Dutch, Canadian and Australian bond yields also declined to record lows. It is quite absurd to see yields drop to record lows at a time when government debt is reaching all-time highs.
Total US government debt amounts to USD 15.8 trillion today, which is more than three times as much as it was in the year 2000.
We believe that this fear surrounding the Euro crisis is a bit overdone and it reminds us of the hype ahead of Y2K. With traders all over the globe deleveraging ahead of a potentially cataclysmic event in Europe, it may eventually turn into a ‘sell the rumor, buy the fact’ situation.
We don’t want to downplay the problems in Europe, as many economies there are in deep trouble, but so are the US, Japan and to some degree even China. While we agree with the analysis of the current scenario, we feel that traders are reaching the wrong conclusion in regards to the fallout from this deepening crisis.
Although deflationary forces are clearly at work, central bankers around the globe have basically unlimited powers to prevent a collapse in nominal prices. While the Fed and its counterparts may have taken a backseat in recent months to assess whether the global economy would be able to gain some traction on its own, they will be quick to step in again if the need arises.
This week we have already heard from several Fed governors that new stimulus may be just around the corner. We believe that it is just a matter of ‘when’ and not ‘if’, and once central banks intervene, the switch will immediately go to “risk on” again.
When we look at the price of cotton in terms of gold instead of depreciating paper currencies, it is already near historic lows of 16 milligrams of gold per pound of cotton, just slightly above the record low of 14 milligrams/pound in early 2009. In other words, cotton is cheap, although that doesn’t necessarily mean that it won’t get even cheaper in the months ahead.
Cotton’s fate over the coming months will to a certain degree depend on what happens in China. The China Cotton Index (CC index) amounted to 134 cents/lb today, nearly double of what the spot month in NY futures is currently worth.
This dual market scenario is leading to interesting dynamics, especially if the Reserve keeps sitting on its large stockpile of an estimated 18 million bales. All indications are that this is going to be the case at current prices, because the Reserve typically doesn’t sell its stocks at a loss.
This would mean that China would have to import more cotton and/or yarn to make ends meet. Quotas seem to be in short supply at the moment and are trading as high as 3000 yuan/ton in the secondary market.
Could it be that by restricting the issuance of further quotas the government is trying to force the local price to a level at which the release of Reserve stocks becomes profitable?
Instead of paying prohibitively high local prices, Chinese mills may increasingly turn to importing yarn. This will allow them to indirectly gain access to cotton at international prices.
In the first 4 months of 2012 (January to April), yarn imports amounted to 351’868 tons, or 64 percent more than a year earlier, while yarn exports declined by 16 percent to just 112’479 tons. We believe that this trend of importing cheap yarn will become more pronounced in the months ahead.
International supply/demand statistics are probably not properly reflecting this new trend, as they have been scaling down Chinese mill use, but may have neglected to account for thehigher yarn output in other markets, such as Pakistan, India and Vietnam.
So where do we go from here? The market has discounted a lot of negative news during its fall from 90 to 70 cents. Although the trend is clearly bearish and we may see even lower prices ahead based on the dismal statistical picture, we shouldn’t neglect the potential for countertrend rallies.
However, any decent bounce will probably invite additional grower selling, while dips below 70 cents will be an incentive for mills to become more active. We therefore feel that the market is likely to spend most of its time in a new range between 65 and 78 cents in the foreseeable future.