Updated: Feb 22
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 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.
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.