Understanding the US Dollar Impact on the Coffee Market – Part 2 – Predicting the USD

The #USD directly impacts the price of #coffee (and all #commodities): Dollar strength lowers the prices of commodities and coffee, and dollar weakness increases prices. We looked at this in detail in our last Macro article. Therefor predicting the value of the dollar is an essential component of predicting coffee prices.

In this article, we will first outline our case that #monetarypolicy is the primary driver of USD prices, then we will go through how the Fed’s dual mandate drives monetary policy, and finally, we will outline how the US economy drives #FederealReserve policy. Putting this altogether amounts to a philosophy for anticipating macro-USD impact on #commodity prices like coffee.

Interest Rates and the USD

When predicting the US Dollar’s value, we can boil it down to one very broad rule:

The USD is inversely correlated with interest rates.

High #interestrates (contractionary monetary policy) are bullish the USD, and low interest rates (expansionary monetary policy) are bearish the USD.

Therefore, when predicting the US dollar’s value, we are trying to predict how the Fed will affect interest rates.

When interest rates are high, dollars are valuable (because they gain more interest in the bank), and when rates are low, they are less valuable. The federal reserve doesn’t set these rates directly though, they change the supply of money and the interest rates reflect these changes.

Why the Fed Changes Interest Rates

The Federal Reserve has a dual mandate to support the US economy and this support is defined through the dual mandate.

Fed’s Dual Mandate:

1) maintain 2% inflation

2) maintain 4-6% unemployment.

Interest rates are the primary tool to enact their dual mandate.

Since the Fed changes the #moneysupply (and therefore USD bullish/bearishness) according to their view on these two factors, we monitor both to anticipate how they will enact policy.

Before we look at the indicators themselves, let’s examine how the Fed views monetary policy. To put it very simply, the Fed has only one tool with 2 options. They can increase the supply of money or decrease the supply of money.

The Fed will increase the money supply (“expansionary monetary policy”) to stimulate the economy during a #recession (improve employment rates), or (in rare cases) to inflate an overly strong USD.

The Fed will decrease the supply of money (“contractionary monetary policy”) to control #inflation (make money worth more) or to keep an accelerating economy from forming an economic “bubble” (an unjustified inflation of prices).

This is the basic balancing act that the Fed will maintain to support the US economy, but in extreme cases, they may be forced to choose one priority over another.

Regardless of whether balancing or prioritizing one over the other, the Federal Reserve watches these economic indicators closely to determine which of there dual mandates are at risk, and they switch the lever accordingly.

The Other Policy Tool

Investors and traders will also monitor these indicators to anticipate how the Fed will act.

The Fed knows that investors will anticipate their moves, and in fact, they count on it. When I said the Fed only has one tool, that wasn’t entirely true. There is actually another tool as well: communication.

The Fed uses its press releases and minutes releases to intentionally telegraph how they will respond so that the market will move without them having to do anything.

By communicating well in advance to the market, this helps to ensure that public is not caught by surprise by Fed moves. A surprise in the market would create a chaotic repricing in the markets and that is not what the Fed wants. Instead, the idea is for stable and gradual repricing.

Economic Indicators

To understand how the Fed will react to the economy, we need to understand how they see the economy. They do this through "indicators." Indicators are key metrics that provide insight into the economy, and there are MANY of them.

With the vast array of economic data available, the first challenge is organizing them into a useful framework. In this paper we divide the indicators into 2 broad sections: Dual Mandate Indicators and Economic Indicators. We will look at the Dual Mandate Indicators in this article, and in the next article we will examine the Economic Indicators.

Dual Mandate Indicators:

These indicators are direct reports of whether the Fed is achieving its dual mandate. Of course, these indicators are important for determining the health of the US economy as a whole, we are focusing on them in this section as they can be used by the Fed to determine how to act.

It is also worth mentioning, that these indicators are primarily backward looking. In other words, they come out weeks and months after the fact. This means that the Fed will be less concerned with the actual monthly print, but rather the overall trend.

Inflation indicat