Changing Landscape in the Coffee Market
The #coffeemarket is in a very different dynamic than it was 3 months ago, and we are getting near to a new paradigm: the bear market.
In this article I will outline some of the warning signs that we are entering a bear market in #coffee and highlight some key data points to watch. I’ll also highlight 2 key areas that can change the #coffeefuturesmarket and return coffee to new highs.
Still Some Life in this old Bull
While it is time to look out for the bear market, we cannot discount the bull just yet.
Just this recently #CONAB reduced their crop estimate from 55.7m bags to 53.4m bags, an impressive revision lower. This reduction is even more pronounced in #Arabica which dropped 3 million bags from 38.8m to 35.7m bags. While #Robusta by contrast was raised a million bags from 16.9m to 17.7m bags.
Shortly before this, many of the tradehouses reduced their own arabica estimates (and raised their conilon estimates) as well.
The #Supply and #Demand is in the second year of an impressive 2-year deficit, cert stocks are near 5-year lows, we are in the midst of a rallying #commodity supercycle, #differentials are screaming and moreover, the market is in backwardation, so how could we possibly be #bearish?
The main reason is, I think that all of this has been priced into the market and that the trends in these are shifting the other direction.
Coffee prices first went above $2 almost a year ago, has been continuously above $2 since October, and even reached a high of $2.60. All in the midst of an incredibly weak BRL.
This means coffee is not cheap, in USD terms, coffee is rich. In BRL terms, coffee prices are astronomical and unprecedented.
In order for coffee to stay elevated, current problems will need to continue or get worse and the evidence doesn't suggest that that will happen.
#Freight Improvements (despite inflation)
China has recently announced the end of its draconian lockdowns in Shanghai and the congestion that this has caused as a major port city in #China is set to improve.
Even with these huge lockdowns and disruptions to the global supply chains, the global #logistics industry has been innovating and searching for solutions to the bottlenecks (such as #breakbulk shipping in coffee), and freight prices have been coming down.
Moreover, demand for goods had spiked at the same time as initial lockdowns had ramped up in the start of the pandemic. This was because of huge amounts of fiscal and monetary stimulus from governments to citizens to try and avert pandemic induced recession.
Demand Likely to be Negatively Affected
Despite demand improving from the lifting of lockdowns, I see some anecdotal evidence that demand may not be looking so hot after all.
From a macroeconomic point of view the Stimulus chickens are coming home to roost as inflation has skyrocketed around the globe. The world’s central banks now need to raise interest rates to control inflation.
While unchecked inflation can stimulate demand, the opposite is true when inflation is reigned in. During inflationary periods consumers decide to spend their money rather than have it lose value in the bank. This trend will likely shift with raising interest rates.
Central Banks raising interest rates will incentivize saving and take money out of circulation which will dramatically reduce demand for goods and services. It will also crash the stock markets (already happening).
Crashing the #stockmarkets has a negative effect on spending because it reduces the “wealth effect”. The wealth effect is where consumers feel rich when they have impressive IRAs and investment accounts and therefore don’t mind spending more. However the opposite is true when the stock market crashes.
In addition to the wealth effect, the stock market represents businesses and business are the key consumer for commodities. With cheap money drying up and consumers reducing spending we will likely see a contractionary cycle for businesses.
This contractionary cycle coincides with generally increasing supply in response to historic high prices in commodities.
Coffee Supply
There is still uncertainty about the amount of coffee on the trees to be harvested for 22, although current estimates are for less than 35-39 million bags of Arabica which is really poor for a bumper crop. However, conilon estimates are rising with many analysts, agronomists and tradehouses seeing 22-24 million bags.
More interesting is the potential for the 23 crop, which looks to be making a spectacular recovery with excellent growth. It is still too early to say what the crop will be, as many factors can influence the crop size between now and next year, but the current potential is phenomenal.
Historically, coffee prices are strong for Arabica and Robusta and this should incentivize farmers around the world to care for their coffee and increase production where possible.
Weakening Calendar spreads
#Calendarspreads have been #backwardated and exceptionally strong over the last year reflecting logistical problems, #certstock tightness and back-to-back global deficits. This #backwardation has collapsed back into #carry in the front month and is greatly diminished across the curve.
This is a key indicator as calendar spreads often reflect the fundamentals better than the outright as currency, trend following and other influences are largely arbitraged out of the price.
This relative weakness (well off the highs, but still “rich” in absolute terms) across the curve demonstrates a trend of diminished demand for new stocks as compared to 6 months ago when the market peaked at +2.5c inverted in N/U.
The weakening trend in spreads suggests that current tightness has been priced in already and the market sees diminished risk in the future.
The main exception to this is the N23/U23 which represents the period of peak tightness before the 2023 Brazil crop. I suspect that this spread will be the last to move back into carry as it holds the most risk.
Long Spec, No Shorts
On an outright net basis, the COT is bearish when we consider the over participation of long specs vs shorts. Although long positions are still way off the highs, they are vulnerable to further sell-offs as they are the only specs in the market. Normally a bull market has spec longs outnumber the shorts but rarely are they as one sided as they are now.
Just last week, we saw a brief entry of spec shorts in the market that were forced to cover, rallying the market 20c in just a few days on early frost fears. These shorts are now gone from the market but the longs are still there and they have the potential to liquidate and in doing so push the market in the opposite direction.
The lack of a spec short in the market right now indicates that their “powder is dry”, meaning that they have money sitting on the sidelines waiting to enter the market. I think we are unlikely to see a strong spec short position return to the market until the spread curve comes back in to carry, but as indicated above, we are very close to that happening.
Weakening Economy/stronger dollar/weaker BRL
The inflationary global environment has been boosting prices around the world, but this trend is under threat from two fronts.
First, the #USD is ripping, with the promise of strong rate increases from the Federal Reserve. A strong dollar has a direct negative impact on commodities (as they are priced in USD terms).
Second, the strong #dollar and hawkish #monetarypolicy has a strong chance of crashing or at least reducing the power of the #USeconomy and a #recession may be the only cure for #inflation.
Coffee consumption tends to be recession proof in much of the mature coffee markets, but in newer coffee cultures coffee is a luxury and high prices combined with a weak economy can reduce consumption on the margin. Even in cultures where coffee is considered a staple of everyday life, a recession can shift consumption from expensive coffee shops and high quality arabicas to cheaper alternatives from Robusta coffee.
Returning to currency for a moment, the BRL is inversely related to the USD and European currencies, and after enjoying a strong market from their own Central Bank tightening cycle, the BRL has the opportunity to weaken again comparison. Economists are increasing their expectations for the BRL exchange rate, implying a weaker fair value for the currency.
On top of that, elections are coming up in a few months in Brazil and (anecdotally) this often has a negative effect on the currency.
A weak #BRL means Brazilian producers receive more BRL’s for the coffee sold, implying more selling to exporters who hedge in the futures market.
Technical Signals
Despite the latest weather-related rallies, #technicals are overall getting weaker, and have largely shifted bearish.
A bearish 20/200 SMA cross recently took place, this is the first time this signal has occurred in nearly a year and a half. This is an important negative long-term sign and is a good proxy for momentum #quant funds. Prices have also penetrated long term support from both of these moving averages as well.
Biggest bull Arguments
All the above considered, there are still bullish arguments to be made. First and foremost comes from the weather.
My main concern in #Brazil right now is the #dryness. #Rainfall in Brazil has been below average for sometime now, and the forecast also looks neutral to dry.
This is mitigated somewhat because strong rainfall earlier in the year has left the plants in excellent condition, but that will only last so long. It is also the dry season (harvest time) and so having less rainfall than normal is not the worst thing in the world. However, it is getting to the point where I’m becoming concerned that if we don’t get some relief in the next few months its could make for a weak start to the next crop.
Nothing definitive yet, but it is most definitely on my radar as a potential problem.
Also of concern is that we are entering the frost season in Brazil. Winter hasn’t started yet (begins on June 20th), and the country has already received unusual frost alerts and even limited occurrences, along with low temperatures these last few weeks.
A 20c rally (since retraced back), gave a hint of what’s to come in case we have another big frost this year. The dry weather, I am told can have increase occurrences of frost, and the extended La Niña this year means that we could see more frost this winter.
Usually frost is not a major issue (with notable exception of last year!) as the coffee crops in Brazil have tended to move Northward out of the frost areas.
This winter will be an important inflection point that can dictate the future of the coffee market. If we have a frost of a meaningful size, then the market will likely reach new highs and won’t back off soon.
Less Arabica then expected in Brazil
While the market seems to be coming closer to consensus that the 22 Brazilian crop size is much smaller than hoped for, there are still some outliers that claim the crop is astronomically tiny.
If those outliers are correct, and the market is wrong that could potentially be a short term game changer.
Low Spec position
Although the spec position is long and therefore generally bearish, it is still rather low, in absolute numbers. Longs are way below the February highs and also below the 5-year average for their position while shorts are extremely low, near zero.
New Spec longs can still enter the market in meaningful size at any time, especially considering we still have inverted back months and we are entering a volatile weather season of the year.
Conclusions
Although I think that the forward looking market is concentrating more on the strong potential of the coming 2023 crop in Brazil, and the bearish macro-economic drivers, it is clear that there are still risks in both directions.
I’m reminded of something one of my old mentors used to say, “the real trade is the bear market”. What he meant was that it can be very hard to predict bull markets in commodities (especially where weather is concerned), but that the force of gravity will eventually take hold. Commodities are not equities that go on multi-generational bull markets. A bull market rallies prices, stimulates supply and collapses. That is the way of things.
This was also mentioned in different words by renowned softs trader Anthony Ward in his interview. We all know the Coffee market is going to collapse at some point, and that will be a great trade, but getting in too early could be very risky.