NY cotton futures collapsed

NY futures collapsed this week, with May dropping 2470 points to close at 177.23 cents, while December fell 1765 points to close at 115.74 cents.

Panic short-covering had provided the fuel that boosted the market to new historic highs last week, but as soon as most March shorts were finally out, the buying stopped and the market collapsed into a vacuum.

After the wild session last Thursday, during which March traded has high as 222 cents and May reached above 216 cents (via spreads), a powerful key reversal ensued on Friday, forming an impressive and very bearish 14-cents tall "black candle" on the daily chart. In fact, this was the biggest black candle the cotton market has ever seen in regular trading. This momentum shift was confirmed by the huge volume of 68'678 contracts and another big drop in open interest. Since peaking at 223'405 contracts on February 9, total open interest has dropped some 45'000 contracts to currently 178'450 contracts.

From a technical point of view there were warning signs that a momentum shift was about to occur. The parabolic nature of the move accompanied by the above-mentioned drop in open interest signaled that caution was warranted. Since futures were locked the limit and options trading was halted last Thursday, it prevented spec longs from taking profits, which led to pent-up selling pressure on Friday. With a 3-day weekend ahead and plenty of trouble brewing in oil-exporting countries, speculators suddenly seemed to be in a hurry to take some of their bets off the table.

Therefore, what was expected to be a relatively shallow correction has gained a lot of momentum, mainly due to the uncertainty on the global political front. The turmoil in Northern Africa and the Middle East and the resulting spike in oil prices have prompted some deleveraging of positions by hedge funds and speculators. This latest 'flight to safety' has put some pressure on a number of commodities as well as equity markets and has led to a spike in bond prices.

Money managers fear that the unrest could eventually spread to Saudi Arabia and cause energy prices to spike even higher, thereby jeopardizing economic recovery. Brent crude oil rallied towards 120 dollars/barrel last night but has since cooled off again, closing the session at 111.36 dollars/barrel. However, Brent crude has gained some 40 dollars/barrel over the last six months and combined with much higher food prices it all but guarantees that inflation will accelerate over the coming months. This puts policymakers between a rock and a hard place, because fighting inflation means higher interest rates, which the still weak and debt-laden economies of the West can ill afford at the moment.

Sticking to an accommodative monetary policy on the other hand would further stoke inflation, with abundant amounts of cheap money chasing a limited amount of goods and tangible assets. Given these circumstances and the inabilityby policymakers to take control of the situation, we believe that the most likely outcomes are either 'stagflation' or 'inflationary depression'.

Such an outlook makes it difficult to forecast cotton prices, because the 'stagnation' or 'depression' component points to lower consumption and hence a bearish price scenario, while the inflation part is telling us that nominal prices of just about everything will go up.

So where do we go from here? Looking simply at the chart, last Friday's key reversal has flipped the switch to short-term 'bearish', with trendline support around 160 cents as the initial target and major support at the 150 level beyond that. However, the cash market paints a more optimistic picture than the futures market. Mills still seem to be in urgent need of cotton for nearby shipment and the basis has strengthened considerably during this selloff in New York. The A-index was still at 215.75 cents this morning and the CC-index at over 209 cents. Also, the Certified Stock of around 220'000 bales has not been relinquished by its owners despite the inversion, which is seen as a sign of strength.

Another friendly indicator is the fact that the inversion persists despite the selloff, with May still commanding an 850 points premium over July. In a bearish market we should see this premium fade away. Speculators are in control of this market at the moment and they may push values even lower over the next few sessions, depending on what happens on the macro front. However, most of the weak longs should be out by now and given the strength of the cash market we expect trade buying to show up at any time. Last week's on-call report still showed 2.3 million bales in unfixed sales on May and 3.7 million bales on July, providing plenty of support. The cash market has been the driving force behind this bull market all season long and it seems to have enough strength left to turn the momentum around again.