UK : Market moves in right direction

NY futures gave back some ground this week, as March lost 175 points to close at 66.96 cents, while December dropped 190 points to close at 74.56 cents.
The long awaited correction finally arrived and it was swift and steep, as March dropped nearly 300 points from yesterday's intra-day high of 69.65 cents. Earlier in the week, additional spec buying had extended the rally, which began on December 6, to nearly 700 points.
In the process open interest increased by over 50'000 contracts, as it measured a record 261'151 contracts or 26.1 mio bales this morning. But after the huge jump in open interest of over 10'000 contracts in Tuesday's session, the market seemed to be ready for a breather.
The market has been overbought by technical measures for quite a while and initially it may have been a void of additional buying that allowed this correction to unfold. However, when the market broke through the up-trend line this morning, selling pressure intensified and values caved in.
What may have added to the weakness over the last couple of days is the rebalancing of the two major commodity indexes, the S&P GSCI and the Dow-AIG. Every year, these two commodity baskets, which form the base for many of the commodity index funds that track them, rearrange the weightings of their individual commodities.
In the case of cotton, these adjustments amount to a miniscule increase in the S&P GSCI of about 0.02%, from 0.80 to 0.82%, while in the Dow-AIG cotton suffers a severe cutback of 0.48%, from 2.96 to 2.48%.
When we try to express that in terms of how many contracts will have to be bought and sold to account for this readjustment, we come up with about 800 contracts that have to be bought in the S&P GSCI, while it requires the selling of over 6'000 contracts in the case of the DOW-AIG.
Interestingly, the DOW-AIG readjusts its position during the monthly roll period between the 6th and 10th business day, which falls between the 9th and 15th of January. Therefore, it is quite possible that this rebalancing played a significant part in the selling we have seen over the last two sessions.

From a fundamental point of view it became quite evident that the market had gotten ahead of itself, as buyers were not chasing these elevated values and export sales dropped to a trickle. US offering prices were probably at least 3-4 cents above mills' price ideas.
Tomorrow the USDA will issue its latest supply/demand figures, which are expected to be bearish because world demand is likely to be scaled back further and US exports may also get lowered again.
However, as we have pointed out before, the market has already 'discounted' a much lower world consumption figure than the 128.3 mio bales which the USDA carried in its last report. We feel that consumption is probably not much more than 120 mio bales at this point, which may appear bearish, but let's not forget that this would still be above world production of currently 118.76 mio bales.
Nevertheless, a negative headline number is likely to further feed the downward momentum of this correction.
So where do we go from here? After boosting its short position by an additional 4.5 mio bales since early December, the trade is finally seeing the market moving in the right direction. However, we feel that traders are slowly but surely waking up to the increasing power these long-only index funds have in the commodity arena and that this sell-off may be seen as an opportunity to get out of short positions or to fix some of the 6.7 mio bales in unfixed on-call sales. We therefore expect good scale down support to emerge from current levels on down. Chart traders may try to scalp the market from the short side for a few cents now that the trend line has been broken and some of the weaker spec longs may exit positions, but the core long position in our market belongs to index and hedge funds that are investing in commodities for the long run.
Inflation protection is one of the main reasons for these investors to be in commodities and the more the Federal Reserve juices the money supply by lowering rates, the more attractive commodities look as an alternative investment vehicle.
We believe that we are just at the beginning of a significant asset allocation shift into commodities and that the money that is pouring in as long-only investments will continue to boost open interest to unprecedented levels and in the process inflate commodity prices further.