Our first rule of our coffee trading rules is “Know Brazil, know the BRL”.
#Brazil is the powerhouse of the #coffeemarket. Boasting the world’s largest #production of both #Arabica and #Robusta #coffee, anyone who wants to follow the coffee market needs to know what is happening in the world’s most important coffee origin.
Brazilian coffee #farmers sell their coffee in local Brazilian Reais (plural of Real). This farmer selling is the primary reason that understanding the Brazilian #economy (and its impact on the currency), is essential for coffee professionals. Any move in this currency can have an outsized impact in the coffee markets.
In this article, I will first outline how we analyze currencies, and then discuss two major influences in today’s Brazilian economy: #inflation and #recession, we will look at current events and how to interpret those through this lens, and finally we will conclude with how they relate to coffee.
How to Look at Currencies
When we look at fiat currency in terms of the #FX markets, we are looking at its price in relation to other currencies. The most common currency to cross with is the USD, but we can also compare to other developed markets like the Euro, GBP, CHF and YEN, or we can compare a currency to other similar markets.
When we price a #currency against another, such as the #USD, this is called a “cross” or a “currency pair”. In the coffee world, the USD/BRL pair is the default in the coffee market when talking about the BRL. Since this particular cross is how people price the BRL, it means that we have to also keep an eye on the fundamentals of the US economy as well as the Brazilian economy when examining this pair.
The reason that we have to look at two economies in a pair, is because we are pricing these two currencies relative to each other. This means that they have a symbiotic and inverse relationship. A strength in the USD means a relatively weaker BRL, and vice versa.
However, we also have to consider the relative strength of the two economies when judging the impact. Since the US economy is an order of magnitude larger than the Brazilian economy, the USD will always have a big impact on the BRL, but the BRL will not have as much impact on the USD (unless it is part of a broader movement in several economies).
When we look at the fundamentals of the currencies, we are basically trying to identify the supply and demand for that particular currency.
The demand side comes from the strength of the economy. In the case of Brazil, a strong economy will imply that there is a lot of demand for Brazilian Reais and so the increased competition for currency can drive up its value. A weak economy would imply that there is not so much demand and have the opposite impact.
The supply side of a currency is driven by monetary policy. For this, we need to look at the Central Banks. Traditionally a Central Bank has two mandates: 1) to keep unemployment low, but not too low (4-6%) and 2) to keep inflation low, but not too low (target 2%). The central bank does this through increasing or decreasing the supply of money.
An increase in the money supply is intended to stimulate the economy by making the cost of borrowing money cheaper. When it is easy to borrow money, businesses and consumers can get loans to invest and consume and the hope is that this will reduce unemployment and stimulate the economy. However, this also comes with the downside of raising inflation.
A decrease in the money supply can slow an “overheated” economy and is also a tool to reduce inflation, but this has the downside of increasing unemployment. There’s no “free lunch” in monetary policy!
Both the supply side and the demand side of economics affect each other as well. If the demand side of the economy is poor, we might expect the central banks to increase the money supply. If the money supply is being tightened, we should expect the economy to contract.
This relationship is further complicated by the fact that markets are forward looking. At any given moment, a currency is trading not just the economic reality, but also the sum of expectations, forecasts, trends, and momentum.
This can create a trading environment with a lot of uncertainty and conjecture, especially when looking at the USD/BRL cross since we need to consider the economies, money supplies, sentiments, and forecasts of two very different countries.
BRL Impact on Coffee
The reason why we care about the USDBRL cross in coffee is because the C Market for Arabica coffee is priced in USD/lb, while the world’s largest seller of coffee is priced in BRL. This means that the exchange rate can have a significant influence on prices.
A weaker Brazilian real is a negative for coffee, because a weaker BRL (vs the USD) means Brazilian farmers would earn more local currency with their sales. This increase in sales would translate into more hedging in the futures market from exporters and would put downward pressure on prices. The opposite would be true of a strong BRL.
The terminology of weaker/stronger BRL can be confusing when looking at a chart. The USDBRL cross is the number of BRL that 1 USD purchases. Therefor a higher number is a weaker BRL (1 USD buys more BRL) and a smaller number is a stronger BRL (1 USD buys less BRL).
Current Events in BRL
A weak BRL is the environment that we have been seeing for some time now. The currency has been testing the upper end of it range at 5.70. The economic outlook and data from Brazil can be seen as negative, although it’s not clear whether we are close to peak pessimism or not in that country.
While the economic fundamentals for Brazil are sketchy, the USD has been struggling to maintain its bullish momentum, and if the USD continues to falter it will by default strengthen the USDBRL cross.
Inflation and Brazilian Monetary Policy
In the wake of the Covid epidemic, central banks around the world enacted easy money policies to stimulate the economies. The predictable but unfortunate consequence of this has been inflation that is now closing the year at 10%, and 10.74% accumulated in the last 12 months.
Inflation is caused by monetary expansion, but has also been further exacerbated by supply shocks and logistical crunches globally.
To combat this, the Brazilian Central Bank has been pursuing an aggressive policy of monetary tightening sin Dec 2020, and even increasing interest rate increases by 50% since October 2021. Since the beginning of 2021, interest rates have risen from 2% in January, to 9.25% today.
Despite this, the BRL has struggled to strengthen.
To make matters worse, the economic growth has been curtailed by the BCB’s policy, remember that a tight monetary policy is a drag for the domestic economy. Latest Brazilian unemployment figures came out recently, and have declined from 12.6% to 12.1%, slightly better than expected. This is a lightly better scenario vs the average 14% rate of this year.
However, if we compare it to the US, that usually maintains around 4-6% unemployment, it shows that Brazil’s job situation still has a lot of improvement possible.
Even with the news of less unemployed Brazilians (vs last release), t
he worker's usual real average income dropped to the lowest value ever recorded in the historical series of the (IBGE) research on account of the dratic inflation.
Brazil entered recession after 2 consecutive semesters of GDP decline, lowering 0.1% in the third semester.
Based on Brazilian Central Bank’s failure to reach its inflation goal, along with the side effects in the economy, right now it does seem possible that the tightening monetary policy could be abandoned in favor of addressing the recession. This would mean an expansionary monetary policy, leading to a we
Brazilian Economic Uncertainty and Fiscal Policy
Investors also seem particularly fearful of Brazil's backdrop of uncertainty and economic fragility. Fears about fiscal discipline next year have appeared after the government managed, through the "PEC dos Precatórios", to change the spending ceiling rule.
This generated the perception among part of the markets that Brazil's fiscal rules could be subject to further changes in the future to accommodate more spending. This has served to undermine confidence of foreign investors in the country and is one of the reasons we see some bearish forecasts for the BRL.
President Bolsonaro recently supported "Auxilio Brasil", a program built to help over 17 million people with monthly payments of R$400. The effect on the BRL is ambiguous, on the one hand it is clearly inflationary, with more money being pumped into the economy. On the other hand, this may stimulate demand and increase demand for local goods and services, which would potentially be good for the economy.
USD Weakness Helps BRL
Prior to the recent struggles in the USD, the dollar was expected to benefit from accelerated tapering (reduction in monetary expansion) and upcoming (US) rate increases. This dollar strength would have been negative for the BRL, however, this bullish dollar momentum has stalled. If it continues to weaken, the BRL could see its fortunes reversed to strength.
The USDBRL cross is an essential indicator in the coffee market for determining the price of coffee. The fact that the world's largest seller of coffee (Brazil) prices their sales in BRL and the international futures market is priced in USD mean that this cross will always have a large impact on the futures market. Think of the relationship from the perspective of the Brazilian farmer: a weaker BRL means that he or she will receive more cash for the coffee and will draw out sales. A strong BRL means that they will receive less cash for their coffee and the farmer will raise their offer.
When looking at a currency pairs we need to consider the economic strengths of both currencies, as well as their relative strength. Economic strengths and weaknesses will also influence the actions of central banks, who are trying to maintain an equilibrium around ideal targets of inflation (2%) and unemployment (4-6%).
With this in mind we examine economic outlook and for Brazil is still far from optimistic.
The domestic economy is clouded by a lot of uncertainties and may be pushing away foreign investors. The upcoming elections are also further compounding this.
Overall, we see the case for a slightly negative (bearish) view on the BRL which would be a negative for coffee, however, if the USD continues to struggle this could overshadow the impact of the Brazilian fundamentals and cause the BRL to rally regardless.
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