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Real Deal on the Brazilian Real: How Brazilian Forex Influences the Coffee Market

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

The Cross

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).


Fundamentals

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.