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Understanding the US Dollar Impact on the Coffee Market - Part 1

Updated: Feb 22

#Coffee is both a financial product and a global #commodity. It is cultivated, consumed, shipped and traded across almost every country across the globe.

Due to its global nature, the US #dollar performs an outsized role as a common #currency in the #trade of this product. Notably, the two primary #coffeefutures #markets (ICE Eur and ICE US), are priced in #USD. This makes understanding the purchasing power of the US dollar foundational to understanding the price of coffee.


Every day the purchasing power of the US dollar fluctuates, and this causes a direct impact in the coffee market. This is independent from the #fundamentals, a change in the dollar value will change the price of coffee.


In this article, we will discuss how to think about the USD’s impact on coffee. We will start with a framework for understanding the dollar, then we will show how to measure its value, and finally we will look at how that value directly impacts the price of coffee.


This will be a 2 part series, in the next article, we will dive into the black magic of currency forecasting, so that we can anticipate how changes in dollar valuation will impact the #coffeemarket.




Understanding the USD

To understand the USD’s impact on the coffee market, we need to concretize the abstract concept of “currency” into value. USD value, much like a commodity’s value, is derived from #Supply and #Demand.


This means that basic scarcity principles apply: when supply increases, value decreases. When demand increases, value increases. The sections below detail how the supply and demand for dollars changes.


Supply

Supply of dollars is a relatively easy thing to understand. The #FederalReserve bank of the US (the equivalent of a #CentralBank) determines the supply of money through the Federal Open Market Committee which buys and sells government bonds to increase or decrease the money supply.


When the Federal Reserve buys bonds, they give cash to #bond holders (increasing the #MoneySupply) and hold bonds on their balance sheet. When the Fed sells bonds, they take cash from bond buyers (decreasing the Money Supply). In this way, the Fed can control the supply of money in the US economy.


Generally speaking, the Fed will change monetary policy to try and stabilize the economy. During a recession, the Fed will expand #monetarypolicy to stimulate #investing and #consumption, during a bull market, the Fed will contract monetary policy to control #inflation.



Demand

The demand for USD is a little more complicated but can be understood as comparative spending opportunities. When there are more spending opportunities in the US currency, we see the demand for dollars increase. When there are more spending opportunities in other currencies, we see the demand for dollars decrease.


We can divide these spending opportunities into 3 areas:

1. US investing opportunities (equities or interest rates)

2. Foreign investing opportunities (equities or interest rates)

3. Global Risk/Insecurity


Foreign countries demand US dollars to invest in the United States (buying US stocks, real estate, etc), to consume US goods (US exports) or to hold as currency reserves. Therefore, one important correlation is that when the US economy is strong, there is stronger demand for US dollars. When the US economy is weaker, there will be less demand.


Similarly, foreign investors will demand US dollars for USD denominated bonds (corporate or government). The demand for USD related to bonds is directly proportional to interest rates. Therefore when interest rates are high in the US (compared to foreign governments), we will see increased demand and the dollar will rally, when interest rates fall in comparison to foreign countries, the dollar will lose value.



Related to both interest rates and investment opportunities is the relative opportunities in other countries. Currency trading is a zero-sum game, if dollars are being purchased then another currency is being sold, and vice versa. Therefore, when there is a strong purchasing demand for other currencies (due to interest rates or investment opportunities) it will often induce selling pressure in the US Dollar.


This has to do with the fact that the US dollar is a reserve currency. This just means that many countries hold reserves of US dollars, which they convert to other currencies as needed. For example, Mexico might hold 200 million USD in currency reserves, then when they need to buy Colombian Pesos, they sell USD and buy Pesos.


Therefore, in the example above, if the demand for Pesos increases there will be selling pressure on the USD.


Finally, there is one other reason that demand for dollars can increase, and that is as a “safe haven” asset. This just means that when situations are economically volatile, many investors across the world will sell riskier assets like equities and move to cash. Catalysts for economic volatility can be political (wars, elections), geographic (earthquakes, floods, tsunamis), social (pandemics) or related directly to economics (recessions, market shocks). All of these events, or events like them create demand for dollars.


Measuring USD Strength

Since most currencies are backed by government decree (“fiat”) rather than by a commodity like older gold-standard or silver backed currencies. We can measure the value of a currency in two distinct ways: 1) in terms of other currencies or 2) in terms of buying power.


In terms of other currencies is one of the more straightforward ways of valuing a currency. In FX terms this is referred to as a “cross”, as in a USD/BRL cross would refer to how many BRL 1 USD would buy. Since the USD serves as a reserve currency, many currencies are valued against the USD by default, although one could also use the EUR, GBP, YEN or any other currency.


However, because so many different currencies are valued against the USD, there is no single currency that works best as a cross. To get around this, there is an index called the $DXY that measures the value of the USD against a basket of 6 currencies, with 100 as a baseline. Tracking the $DXY will give us a solid understanding of US dollar strength.



The second way of measuring US dollar strength is directly relevant to how it influences the coffee market. We see how much “stuff” one can buy with a dollar. The traditional way of measuring this is to look at an inflation index such as the CPI or PCE. Both of these indices track the amount of dollars required to buy a fixed basket of goods.


When more dollars are required to buy the same goods, we call it inflation. When less dollars are required, we call it deflation. The downside of using these indicators is that what is in the basket can make a big difference.


Another measure of the purchasing power of the USD that is more relevant to is in coffee, is a commodity Index. The BCOM is one such commodity index that we can use to measure the purchasing power of the dollar.



This seems different than a currency cross, but it is the exact same principle. When dollars are in high demand, they become more valuable, and can buy more “stuff.” This makes the prices of commodities go down. When commodities are more in demand, seller require more dollars in exchange for the commodities and the index price rises.


One downside of using a commodity index to value the USD is that the supply and demand for individual components of the index can also influence the value of the index. However, when we look at the basket of commodities as a whole, usually the supply and demand of all of them will be different enough to cancel much of this out.


All of this should go to show, that there are a lot of factors and influences that converge to give us a currency valuation. In the sections that follow, we will go into more specifics on how to use this information.


Direct USD Influence the Price of Coffee

If you are a trader of coffee, it is important to know how the value of the USD will impact the price of coffee. Fortunately, this is a very straightforward relationship.


When the US dollar is strong, the price of coffee (and any dollar denominated asset) will go down. When the US dollar is weak, the price of coffee will go up.

Sometimes it helps to think of it in the extremes. If we consider a hyper inflation scenario, where money is becoming less and less valuable as in Germany after WW1 or Zimbabwe during the early 2000s, imagine a normal citizen going to buy a loaf of bread. Inflation in Zimbabwe peaked at a rate where it was doubling ~24 hours. This means that on day 1, a loaf of bread would cost $2, then $4 on day 2, $8 on day 3, $16 on day 4, and so on.



If you were to chart the prices of bread during this period, it would appear to be a dramatic bull-market. The price of bread would appear to be skyrocketing. However, this would be misleading. The value of the bread was not going up, the value of the Zimbabwe Dollar, was going down.


This same phenomenon happens on a daily basis in US dollar denominated commodity markets like coffee. All things being equal, when the US dollar gains in value, the price of coffee declines.


The “all things being equal” portion of that sentence is important. The price of coffee will change in regard to traders buying and selling it for any reason, so fundamentals, technicals and capital flows will all influence the price of coffee as well. However, when very little is going on in the coffee (or any other commodity) markets, we can see this influence very directly.



Even when other fundamental factors are affecting the price of coffee, the USD value is also still working in the background. For this reason, if we want to be informed about the price of coffee, we need to have a solid understanding of the USD. Since coffee is priced in US dollars (or US cents), the purchasing value of the US currency is really of foundational importance.


In the next article we will show how we can look at economic indicators to try and forecast currency strength.

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