Are Cotton Prices Going Up?
Cotton prices have lost a huge percentage of its value since the end of April.
As a result, eliminating almost everything it has gained in the first quarter of the year. The BAL, which is the ETF for cotton prices, has dropped from the high point of 89.05 in May to 64.84 by the end of last week. Given the high inflation rate in the current US market and the recent lift of interest rate by the Federal Reserve, investors are fearing a recession of the economy. The question is whether cotton price functions as an indicator of the economy or is it just a consequence of the current market’s expectation?
To answer the question, a simple linear regression is performed to test if there is a linear relationship between the cotton price and the market price. SPY(S&P 500 ETF) will be used as the price of the market, and BAL will be used to represent the cotton price.
The dependent variable is SPY, and the independent variable is BAL, because we want to test if cotton price could be used to explain the variations in S&P 500.
When using daily data from July 2021 to July 2022, the regression result shows that the R-squared is equal to 0.175, which means that the regression could only explain 17.5% of the total variances in S&P 500. Therefore, though the F-test suggests the model is valid, and from the T-test, it reveals that the coefficients of BAL and the intercept are different from 0, these do not show there is a strong linear relationship between SPY and BAL. This makes sense if we look at the graph of BAL and SPY as below.
The above graphs are the BAL price and SPY price over the time between July 2021 to July 2022. Clearly, as BAL climbs up to its high point, the SPY just fluctuated over the same period. There is no clear same-direction or opposite-direction movement between the two variables from the above graphs. However, we see that when we move along the x-direction, as the SPY starts to fall, the BAL seems to follow that trend. The question then jumps out is whether BAL is a laggard of SPY. To verify the assumption, another regression is performed on the data between May 2022 and July 2022. The result shows that the R-squared improved to 25.5%, which accords with our assumption. Though the R-squared is still not high, it improved compared to the previous model, and the new model’s T-statistics and F-statistics reveal the coefficients and the whole model are statistically significant.
To conclude, there is no strong linear relationship between BAL and SPY in general, however, when the market is expecting a recession and the S&P 500 starts to fall, the cotton price follows that trend. This conclusion accords with the historical pattern. Usually when investors start fearing a recession, one of the first impacts is a reduction in cotton consumption. (Barani, 2022).
When the economy is tough, clothing and furnishings become discretionary. People will put off buying new garments until the economy enters a better stage. Corporations may delay refurbishments that include new rugs, or fabric-based furniture. (Barani, 2022).
In conclusion, the above reasons make cotton more sensitive to an economic slowdown than any agricultural commodity. Therefore, cotton could not help to predict variances in the market, but it is a laggard indicator of the economy.
