A Macro Boon for Coffee

Yesterday the #BrazilianCentral Bank announced a rate increase of 1% to combat the rising #inflation. This is the largest increase since 2003 and is often seen as a sign of coming appreciation in the #BRL and combined with the some indications of weakness in the #USD could be a portent of strength in the #coffeemarket.

Let's break that down. In the sections that follow, I show a) some background on why these #currencies are relevant to the #coffee market and b) how I think they will evolve in the coming weeks and months and c) what this means for coffee prices.

Brazilian Real/USD Cross

The Brazilian Real has one of the strongest correlations of any other factors to the coffee market. In fact, it is so strong, that when I do #pricemodelling of coffee I will often include one with just stocks to use and one with stocks to use regressed with the BRL exchange rate.

The reason for this is logical but not entirely straightforward.

#Brazil is the world's primary supplier of #Arabica coffee. Arabica coffee is hedged on the ICE US #futures market. So when the Brazilian #farmer sells coffee to an exporter, that #exporter #hedges that coffee with short futures which puts downward pressure on prices. In aggregate this means that when Brazil sells more coffee, the price goes down, when Brazil sells less coffee, the price goes up.

The World's Coffee Production by Origin; Brazil's Production in Blue

However, unlike most other Arabica origins, Brazil primarily sells naturally processed coffee and this is the key to why the currency matters. Without going too into the details here between #washedcoffee and #naturalcoffee, sellers of washed coffees have to sell their coffee to the #exporters immediately after #harvesting. Sellers of natural coffees can wait for weeks or even months to sell their coffees.

Therefore, the Brazilian farmer will wait to sell their coffee until they like the price.

When the BRL is firm the Arabica market seems cheap in local #currency terms and the farmer will hold back their crop instead of selling. This allows the price of coffee to rise.

When the BRL is weak, the opposite happens. The local farmer gets more BRL for their crop and they are happy sellers: they release more coffee into the market. This causes arabica prices to fall.

This is the primary reason for the correlation between Arabica prices and BRL levels.

The secondary reason is a little more of the tail wagging the dog. This relationship is well known, so #spec #traders across the spectrum from #propdesks to #hedgefunds will use the BRL as a signal to trade KC, or even use Brazil heavy #commodities like coffee as a proxy trade for a view on the currency.

US Dollar

No currency exists in a vacuum though, currencies are only have a value when paired with another #currency (a #cross) or a #commodity (price), so the

other end of the currency spectrum that we have to pay attention to is the US Dollar.

Since commodities are priced in US currency, when the US Dollar strengthens, it can buy more "stuff" which manifests as prices dropping. When the US dollar weakens, one can buy less "stuff" with it, so prices rise.

Moreover, the dollar is generally priced relative to a basket of other currencies and most other currencies are valued against the dollar (called a "cross", the "BRL/USD cross" for example is the amount of BRL it takes to buy 1 USD). So when the dollar weakens or strengthens, the opposite generally happens to all other currencies.

Which brings us back to coffee, because the most bullish scenario of all for coffee would be a weak USD and a strong BRL. This would push coffee higher from both ends.

The strong BRL would induce the Brazilian farmer to hold back their selling because they are getting less local currency for their coffee. The weak USD would make the price of coffee (and all commodities) rise because of the weak purchasing power of the USD.

This is exactly what appears to be playing out over the next 6 months. In the section below I show why I say that.

Forex Outlook and the Impact on Coffee

#Forex appreciation/depreciation comes from two primary sources: #government intervention, and #Fundamentals. I'll explain the framework and then will show how this is #bullish for coffee.

Fundamentally, currency appreciates when there is a strong demand for that currency. So if an economy is strong and there is a strong demand to buy goods and services there then the currency will appreciate.

However, this is a concern to local politicians because if the currency becomes too strong then the goods will become more expensive to foreigners and loans will become expensive to local business owners. This causes a contractionary affect on the #economy. Which leads us to the government intervention. In order to counteract a recession or contracting economy, governments will increase the #supply of #money to intentionally #depreciate their currencies. The goal being to stimulate foreign #demand for their locally produced products and make money cheaper for local businesses and thus stimulate the local economy.

There can be too much of a good thing though, weak currencies cause #inflation and too much inflation can decimate an economy as well. Thus governments keep a close eye on inflation and raise interest rates to reduce the money supply which counteracts inflation and hopefully brings the economy back under control.

Forex Outlook and the Impact on the Coffee Market

This is the situation the we find ourselves in Brazil. The Brazilian economy was in rough shape during the pandemic which really hurt the economy there. To revive the economy, the Brazilian Central Bank slashed interest rates to depreciate their currency and stimulate the economy.

This caused dramatic inflation and so they have been raising interest rates since May of 2021 to turn it around (i.e. strengthen their currency). The press release from the August meeting was extremely hawkish. It seems that they are very intent on appreciating the currency and this rate hike was a key step in that direction.

On the Northern half of the hemisphere we had a similar situation in the USA. High inflation from government intervention in the money supply to stimulate the economy. However, unlike Brazil which is seeing Coronavirus cases fall from the vaccination program, US cases are rising again from the Delta variant. Moreover, the fall in commodity prices has convinced the Federal Reserve that inflation is not such a concern. Therefore the US Federal Reserve Board has struck a very dovish tone at their last meeting, dashing the expectations of forex traders who were expecting a rate hike to be pushed earlier.

These two factors of a strengthening BRL and a weakening USD would therefore be an impressive supporting factor for the coffee market if it plays out as I've outlined. If the coffee fundamentals are bullish as well, we could very well see new highs this year.

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