Back in April I wrote a column about the influence of speculative funds on cotton futures prices. The futures market had been rising since December, 2013 and the statistics indicated that roughly 9 cents of what was then a 12-cent rally was due to fund buying. Well, they say what goes up must come down. Since early May cotton futures prices have declined over 20 cents (see the red line on the far right end of Figure 1.) How much has the fund sector contributed to this price weakness?
To review, the federal Commodity Futures Trading Commission collects and publishes weekly data on the position of commercial hedgers, index funds, and hedge funds. In the aggregate, the commercial hedgers (not shown in Figure 1, but including growers, cooperatives, and merchants) are typically more short than long since they sell futures and/or buy put options to hedge their physical bales. We refer to that condition as “net short.”
On the other side, the buy-and-hold index funds are usually always net long (as shown by the dark blue area of Figure 1). The index funds build, roll forward, or liquidate their long positions, but they are never net short. The “managed money” or hedge fund type speculators (teal colored area in Figure 1) can swing either way between a net long or net short position. That is because the hedge funds try to anticipate and follow price trends.
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As is evident from Figure 1, the decline in cotton futures price from the first week of May coincides with a huge drop in the hedge fund position. On May 6 the hedge funds were holding a net long position of over 55,000 cotton futures and options contracts. By July 1 that position had shrunk by 90 percent and then switched to a net short position. That means the hedge funds were anticipating a downward trend and mostly taking short positions to profit from it. Their net short position grew and then fluctuated over the summer. During September 16-23 the hedge fund position became more strongly negative, in association with the bearish news out of China about lower than expected Chinese demand for imports.
The downward spikes in the hedge fund net short position in Figure 1 generally coincide with dips in the most active cotton futures price. Our current statistical modeling indicates a 1.9-cent decline in the most active cotton futures price for every 10,000 contract increase in the hedge fund net short position. That means since May hedge fund selling accounts for about 11 cents of the 24-cent decline in the most active cotton futures price. Index fund liquidation made another, smaller contribution to that price weakness. These results highlight the role of hedge funds as a catalyst to market movements. If they are “guilty” of anything, it is that their swinging back and forth from long to short exaggerates price swings and contributes to volatility. Grower-hedgers should be mindful of their influence and their patterns.