In the previous free article, we discussed the dynamics of hedge fund positioning in the coffee market generally. In this premium article, we will look more specifically at what has happened over the last few weeks in coffee futures, and what to expect in the future.
Funds Positioning: Looking Back and Looking Forward
Funds had a strong embedded short position (~32k lots) lying from 147 to 168c. As the market rallied above 147c, P&L losses forced funds to liquidate most of these short positions, and since Oct 11th, short covering has exploded into a major rally in Arabica.
Therefore, it's likely that the recent rally was extenuated by spec-incited volatility rather than based on new information on the fundamentals, especially if we consider that Fundamentals look mostly accommodative, with global surpluses projected for the 23/24 and 24/25 seasons with no significant weather shocks projected.
Looking at the COT during from Oct 11th - 24th, we can see that funds covered short positions in large amounts (32k lots) during this period. This demonstrates that a significant portion of the buying in the market was specs with losing short positions who were forced to buy back their positions at a loss.
Looking forward, we think that at present the longer-term trend supports a return to bearish positioning (new spec shorts). As discussed, funds follow trends, and the two-year KC chart reveals a sustained downtrend that remains intact despite the rally of these last weeks.
Moreover, despite the strong rally yesterday, bullish momentum faces some challenges, such as the 200-day SMA resistance level and healthy selling from origin. Meanwhile, the Relative Strength Index (RSI) has generated a sell signal, suggesting a shift to a bearish trend.
Additionally, the funds are responsive to macroeconomic factors, and the foreign exchange (FX) landscape currently appears bearish (given the strong USD and weak BRL), which forms a strong incentive to short positioning. Now that the funds have covered their shorts and instituted new weak longs, we can say that funds have room to initiate new short positions and the longs are now vulnerable to liquidation if prices sell off. Gross Short Managed Money's are near the average level on an outright basis, which means that they can add 100 thousand lots before reaching their historical maximum short.
Looking more closely at the recent rally (Oct 11th to 24th), we had a 1c upswing for every 1537 lots increase in fund position, whereas the 6-month spec-price correlation suggests KC moving ~1c for every 1 thousand lots change in fund positions (96.2% correlation). Consider that if funds re-add the 32k lots of short positions lost, that would generate a downtrend, which would likely force out ~4k lots of longs. The data therefore suggests that these -36k lots could push KC down by ~24c from 168c, meaning the market would be back towards 144-145c in a few weeks or less.
However, this movement would only place funds back near the 8Y average levels, meaning there would be room to go beyond and shorter. Note that funds got max long amidst the 2021-2022 rally and max short during the bear market of 2018-19. If we consider their bias should evolve bearishly, it’s more likely that they follow the footprint of 2018-19 rather than 2021-22 and start drifting towards max short.
If hedge funds execute only 60% of their max short potential (60k lots) amidst 2024, it will correspond to a ~48c selloff, placing the futures market at the 110c range 6-month to a year forward. Considering that there’s not only a downtrend in course, but currencies are also a liability and fundamentals look rather optimistic in terms of supply, we believe that there’s plenty of motives for funds going short again over the next several months, and so a market inside the 100-120c range seems feasible.
Considerations: Identifying Bullish Risk
Although our positioning view is bearish, we acknowledge that there’s strong bullish risk from short covering above the 167c threshold (200 SMA), as there are ~13k lots of shorts placed between 165c and 175c. Hence, note that any rallies above the 200 SMA will rapidly target the 175c area, assuming 1c move per every 1.5k lots of spec position.
It’s important to note that the bullish risk exists, as well as the main current factors that have potential to engage a rally, notably the dwindling cert stocks and Brazil weather. Cert stocks are drawing at historically low levels (-58.8k bags since Oct 12th, currently at only 389k bags, which is a 5Y low) and there’s no pending volume to replenish so far. Moreover, Brazil’s long-term precipitation forecasts have been oscillating between dry and ok (currently looking ok), which means that there’s not a strong guarantee of abundant rainfall for crop maturation. This is not a huge issue, as the health of the plants at this point is very strong, but there is some bullish risk there.
All told, we must conclude that these are important factors to watch, and if they accelerate (certs continue drawing or a drought sets up on the BR forecasts), they can lift prices and attract new spec longs to the market.
Conclusions
Short covering has exacerbated a rally in Arabica, and now there’s strong downside vulnerability in the market from short fund positioning, as specs may re-engage with shorts. Thus, we lean towards bearish positioning in the timeframe spanning from 1-month and beyond, since different factors (like technicals, FX and fundamentals) support a bearish outlook and funds have built capital to go short again. However, we acknowledge bullish risk above the 167c threshold, KC moving away from this level, which is safeguarded by resistance at the 200-day Moving Average.