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End of the Rally?

Over the last month and a half #coffee has lost 50c or nearly 20% of its value from peak to trough after a historic #bullmarket that saw prices more than double from Jun 2020 to Feb 2022. The question that we are all asking ourselves now is this: is the rally over?

To answer this question, I will outline the setup that got us to this point, examine the new factors that have changed the calculus and identify some key signals that will offer a clue as to where we are going.

Supply and Demand Context

We are currently in a deficit market, and as per usual it was driven by #Brazil.

The global coffee #supply and #demand balance and Brazil’s biannual cycle are the keys to our framework for understanding the market, and Brazil’s crop pattern is a key driver to what will happen with the market.

For context, the global coffee supply tends to follow pretty closely with global coffee demand. We can see that over time surpluses and deficits tend to range between 1 – 5 mm bags.

This is Adam Smith’s old invisible hand at work. When supply gets too big, prices fall which discourages production (farmers who are able, switch to other crops). When supply is too small to meet demand, prices rise which encourages production and discourages demand.

There is a lot of volatility in this arrangement though, because coffee trees take 2-3 years to produce coffee so the supply reaction is quite slow. This inertia in supply makes for bigger bull markets and deeper bear markers. (that’s why specs love coffee futures)

As you might imagine, prices are high during deficits and low during surpluses and the current bull market is the result of a particularly large deficit in coffee.

Biannual Cycle and Brazil

However, its not just the invisible hand that helps to keep the balance, its Brazil’s coffee cycle.

Coffee trees in general tend to have an on-year and an off year. That is, the tree expends a lot of resources to produce large quantities of beans one year, and then the following year will recover and produce less beans.

This yin-yang relationship is also true if #weather impacts the tree. So if a coffee plant is stressed by drought and frost one year, it will generally have a big year the following year.

This biannual cycle is particularly pronounced in Brazil as the coffee producing region as a whole can be considered something of a microclimate with similar conditions (not entirely true, but true enough).

This biannual cycle in Brazil is common knowledge, so the market takes it into consideration when evaluating the impact of global surpluses and deficits and Brazi’s biannual cycle holds the key to the market right now.

The Brazil 20/21 crop was large and helped to fuel a global surplus that made prices low and the world very comfortable with supply. Thus when the 21/22 crop year was forecast to be down, this was not a major cause of worry—its always a down year after an upyear. However, a major drought caused the 21/22 crop to be even lower than initially thought and the market began to rally. Still, the market was not too worried because even a very bad year would soon be followed by a very good year.

This is where things got crazy. The worst frost in a generation hit the crop during the 21/22 harvest that decimated the potential of the on-cycle 22/23 crop. Now there was a problem, and price skyrocketed.

The Present Expectations

Now we stand on the cusp of harvesting the 22/23 crop and people on the ground are divided in their opinions. People who I respect with boots on the ground hold some large differences of opinion on the coming 22 crop. Everyone agrees it was hurt by the frost, but there could easily be a spread of 5-7 million bags on the extremes.

This makes a large difference because it is the difference between back to back deficits, or a deficit and modest surplus. Moreover, as we are on the cusp of harvesting the 22 crop now one thing that is agreed upon is the massive potential of the 23/24 crop.

After the damage from the frost, Brazil had historic rains that were unable to recover the 22 crop but did facilitate new growth for 23 crop. This means that the market only needs to survive for another year before we get a massive surplus of coffee.

On top of this, we also have the demand side of the equation to consider. Demand is still somewhat soft with Covid dragging on and it is becoming clear that the world will never “go back to normal”.

To clarify, I do think that restrictions will be lifted (and have already been lifted) in many places. But the world has also changed in ways that don’t seem likely to be returning. Remote work and zoom calls are here to stay. Amazon and delivery services are not going to be replaced by brick and mortar stores and the travel and tourism business has still not recovered.

To make matters worse, is the increasing global conflict between the world powers. Russia is decoupling itself from the global economy, and there does seem likely to be a demand impact in the near term at least. There is an increasing probability that there will be military action between Taiwan and China.

We certainly hope that this is not the case, for the human cost. However, putting my analyst hat on this could further impact economic decoupling between East and West and also potentially hit coffee demand.

We also have that global instability could continue to inflate the US dollar which would be a pressure on coffee prices.

Looking Forward

I often say that markets are forward-looking. The participants in the coffee market understand what the present is and they are pricing in the above future scenarios. In terms of immediate factors to watch, first will be the 22/23 harvest progress. Which end of the spectrum is it confirming?

Second, will be the demand situation, is the global political environment heating up? Is travel and tourism resuming? What are annual reports of large coffee shops and grocery brands showing? Certified inventory and stock drawdown will also be key confirmation of demand.

Finally, let us not forget the speculator. The 200day SMA and to a lesser extent the 20 day are both good proxies of system fund activity. For now the 200 day has been untouchable and the spec short has been entirely absent. This wasn’t always the case.

One of my former mentors often stated that bull markets aren’t the good trade, it’s the bear markets. We don’t know when a market will rally, but we do know that bull markets will eventually fall. This is something that Anthony Ward mentioned in his interview as well.

To be clear, I’m not super bearish in the present. I’d like to see more confirmation from the current 22/23 crop before declaring the rally over. I’d also like to see a replenishment in destination stocks (we’re at 5 year lows in the US!). However, I think that the above indicators will provide some insight on when the trend has shifted.

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