#Russia has begun aerial bombardment of #Ukraine, including in the capital city of Kiev this morning. What many had hoped (including me) would be a limited and bloodless territorial dispute is now looking like full-scale #war.
As a military veteran of two wars, I do not speak lightly of the conflict, it will be devastating to those directly, and likely to seriously alter the global security dynamic that has existed since the end of WW2. However, my role is to offer insight into the #coffeemarket.
In this article I will outline my understanding of how this conflict will affect the financial markets, including first, second and third order effects, with a particular focus on #coffee. My conclusion is that it will be #bearish for coffee in the short term due to #riskoff and the #spec position, but that it may actually be supportive in the longer term if it contributes to an inflationary environment.
First Order Effects—Risk Off
The immediate impact of the conflict is to trigger what people involved in markets call “risk-off”. Global investors tend to have a risk-on and risk-off mindset. When times are good, investors put money in riskier assets with the goal of getting higher returns.
“Risk-on” primarily includes equities in either developed or developing markets and may include the currencies of those developing markets. It can also mean speculative interest in more exotic asset classes such as crypto, commodities, and yes, coffee. (I had a medical professional cold-call me the other day to tell ask me my view on the coffee markets--there are a lot of amateurs in the coffee market now).
The opposite of #riskon is, of course, “risk-off”. This mindset affects investors when times are uncertain and the financial world becomes fearful. Global conflicts like wars can trigger risk off, as can financial shocks like the global financial crisis of 2008.
During risk-off events markets tend to be driven towards “safe-haven assets”, in particular #Gold and the #USDollar. This also includes sell-offs in risk-on aspects (S&P500 down 2% this morning). In the lead up to this particular event, we have seen gold rally significantly while the US dollar has been more muted.
The US Dollar has been more muted because it has already rallied significantly on the US economic improvement and the expectation that the #FederalReserve will begin raising rates soon. There was also some skepticism that Russia would launch a full-scale invasion vs recognizing separatist regions in the Eastern Ukraine as breakaway republics.
The #commodity markets are mixed as energy is rallying hard (up 5% this morning), and energy makes up a large portion of the index and wheat is exploding (up 10% in a few days). Ukraine is a major wheat producer, and Russia is an energy exporter so the invasion is very disruptive for those markets. For coffee, the market has reacted with a sell off. Not a fearful, screaming, sell off, but a modest sell off of about 2%.
Second Order Effects—Dollar Pressure and Spec Unwind
After the initial shock of the invasion, we will begin to get a clearer picture of what the scope of the conflict will be: whether a prolonged street to street fight, a negotiated surrender, or a limited engagement. The more the conflict seems in danger of spiraling into other markets and aspects of life, the more the USD should rally and risky positions will unwind.
We wrote in a previous article about the relationship between USD and commodities and coffee. The general relationship will be that as the dollar strength increases, commodities and coffee will become relatively cheaper. This translates into sell offs in those markets.
There are 2 important exceptions to this.
First are those commodities that are directly impacted by the conflict such as #wheat and #energy (mentioned above), and the second is if the #fundamentals of that commodity are so strong that they trump the macro considerations. It is possible that coffee may fall into this latter camp, but that seems unlikely over the next few days unless we see something dramatic in the #certifiedinventory.
The dollar inspired selloffs in commodities and general risk-off mindset may also instigate a particular vulnerability of the coffee markets, the spec position. There is a long position of in coffee that is extremely one sided. We are near the all-time highs in net spec length as a percentage of OI and there are practically zero shorts.
It is not out of the realm of possibility that the macro events spark a selloff in the spec long position and may inspire some brave shorts to enter the coffee market.
Keep in mind that the conflict does nothing to solve shortages of inventory or replenish the Brazil crop, but the spec movement alone could create serious volatility in the price.
Third Order Effects—Foreign and Monetary Policy
The third order of effects that we have to consider are first monetary policy of the Fed. The Fed has all but guaranteed that they would start raising interest rates and tightening the monetary supply after the most immense expansion of the money supply the USA has ever seen. This tightening of rates was expected to be bullish for the USD (bearish for coffee and commodities). However, the Fed now has a reason to hold off.
It is entirely possible, especially if the S&P continues to drop, that the Federal Reserve will opt to delay tightening. If this happens, I’d have to expect there to be a sell-off in the USD. This will have to be balanced against the risk-off nature of the environment. If the world is becoming more unstable and the markets more volatile then this could offset the loose monetary policy.
My hope would be that the Fed does stick to its timeline for tightening money, because the US (and many global currencies) need to get inflation under control.
The final piece of the puzzle that we have to consider is the restructuring of the political order. NATO’s response is likely to be economic sanctions, propaganda campaigns and fortification of the Eastern front as Europe looks to establish a “red-line” to protect against further encroachment.
Russia and China are likely going to be pushed closer into each other’s orbit, and China seems likely to support Russia’s move in Ukraine to justify their own moves into Taiwan. The similarities are striking and the outcomes are likely to be similar. Apparently, #Russia and #China have already been making moves to extract themselves from the economic orbits of the #US and Western #Europe and that is likely to accelerate with sanctions.
Conclusions
For coffee, the fundamentals have not changed with this invasion although there could be some impacts on #demand and #logistics. The more foreseeable impact will be on #currencies (especially the USD) and a selloff in risky assets and dollar denominated commodities. The exception to that sell off will be the Russo-Ukrainian commodities like wheat and energy that are impacted directly.
There is a lot of uncertainty as to the future, and bigger concerns than the coffee market. However, for those of us in the coffee markets, the long-term risks include demand destruction and continued or exacerbated inflation.
In the meantime, we hope that this conflict is as short and bloodless as possible.