NY cotton futures rallies again last week (United States Of America)

Plexus Cotton Limited reported that NY futures reversed course and rallied again this week, with December advancing 421 points to close at 76.80 cents.

The choppy trading we have seen over the past couple of weeks is caused by a tug-of-war between a bullish technical and macro picture, and a still rather bearish fundamental outlook.

For traders who have no knowledge of what is happening in the world of cotton and are simply guided by the chart, the recent price action has to be quite encouraging. After dropping to a low of 71.59 cents following the USDA report, the market spent a few days treading water and then started to rally again in the wake of bullish outside markets, as both soybeans and corn posted new record highs of US$ 17.40 per bushel and US$ 8.40 per bushel, respectively.

It is impressive how the market has so far been able to counter any attempts to sell off, which is a sign of strength. Even though December ended the last two sessions with minor losses, it nevertheless managed to close 185 and 117 points above the respective low of the day.

Volume has improved as well during this latest rally, confirming the move, but what has been missing so far is an increase in open interest. During this latest advance, which began last Friday, open interest in the December contract has actually dropped by 146 contracts to 127’696 lots.

Although overall open interest increased by some 2’100 contacts, it is not indicative of strong momentum and leads us to believe that the market rose mainly on short covering, some churning of positions and a temporary lack of selling by the trade.

The current lack of selling by the trade has a lot to do with timing. At the moment we are still in a relatively tight supply situation, since existing stocks in the US are well committed and inventories in other origins are either not readily available (China, India) or are relatively expensive (Central Asia, Australia).

This has caused a temporary bottleneck during which the trade has been reluctant to aggressively sell futures. Also, there is a lot of uncertainty at the moment that keeps sellers at bay, with crops still out in the field, with China’s new crop policy anybody’s guess and with competing crops surging to record highs.

However, once crops start moving in and provided there are no unforeseen weather issues, we should see unsold supplies build quickly, which in turn should lead to selling pressure in both physicals and futures.

Take the US for example, where beginning stocks of around 3.1 million bales and a crop of let’s say 17.0 million bales will add up to over 20 million bales of supply in a few months from now, against which there are just 4.6 million bales in export commitments and 3.5 million bales in domestic mill needs. In other words, there will still be some 12 million bales looking for a home.

Whether this unsold supply is going to be burdensome or not will to a large degree depend on how much cotton China imports this season. According to a report out of China there has recently been a ‘processing trade’ quota of 400’000 tons issued.

However, while import quotas are supportive for the market, it was also mentioned that China would release around a million tons out of its Strategic Reserve at “below-market prices” in order to meet mill demand and to make room for new crop procurement auctions, which are beginning next week.

Although this rumor has yet to be confirmed, any release of reserve stocks would be bearish, because it would come at the expense of imports.

So where do we go from here? Although technical traders and hedge funds may give the market another boost in the very short term, based on a constructive chart and a more positive macro outlook, the impending harvest is likely to change the balance of power in favor of the trade, as it provides it with a lot more ammunition to sell.

The historic discrepancy between cotton and soybean/corn prices will come to the fore at some point in the future, but not just yet. First the cotton market will have to chew through a near record supply of cotton (only seasons 2006/07 and 2007/08 had more availability), most of which remains unsold at this point.

We therefore expect prices to retreat in the October/November time frame, possibly to below 70 cents, which would set the stage for a longer-term advance when we face planting decisions in the first quarter of 2013.