Recently, the Federal Reserve president Jeromy Powell doubled down on the hawkish view, resulting in a dollar rally that contributed to crushing Arabica prices and halting the Robusta rise. The impact of the dollar rally was felt across commodities like Cocoa, Cotton, Sugar, wheat and energy. Now, the question remains about where the dollar goes from here? Will the longer-term bear us dollar trend resume or are we entering a new period of dollar strength.
In our view, we believe that the dollar has room to add more strength over the next couple of months, but that weaker dollar trend would have to resume based on current trends. In this article, we will outline why we hold that view and put the dollar into a broader context and framework for understanding its impact on commodity prices like coffee.
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Why the Dollar Affects the Coffee Market?
Commodities are priced in dollar terms, and this includes our beloved coffee market.
When the USD is strong, buying power increases, which means it costs less dollars to buy coffee, or in other words coffee becomes cheaper in dollar terms. Conversely, if the USD is weak, buying power retreats, and you now need more money to buy the same amount of coffee. This means coffee becomes more expensive in dollar terms.
Thus, USD and coffee share an inverse correlation, as described below:
Of course, this relationship alone does not determine commodities prices. Supply and demand, weather and positioning are primary drivers of coffee prices. However, currency does have a direct impact on the market, so we need to understand how to predict the relative strength of currencies like the USD.
Monetary policy is the largest influence on FX, and for the US, monetary policy is set by the Federal Reserve. In general, interest rate hikes are bullish the USD and rate drops are bearish.
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At his most recent congressional testimony, Fed Chairmen Powell noted that the Federal Reserve should raise interest rates more times this year. This was contrary to what the market was expecting. Powell emphasized the robust labor market and the need to tame inflation while the market thought that this was already under control. This happened just one week after the Fed opted to hold rates steady, and so the statement instigated a reverse in the USD downwards trend, which affected coffee.
Dollar Landscape and its Context for Coffee
When analyzing the coffee market, we are trying to predict the USD strength in order to predict its impact. Much like commodity markets, currency markets are forward looking, which means that FX traders are trading expectations for the future and specifically the expectation for the Federal Reserve’s monetary policy.
The Fed has a dual mandate of maintaining inflation at 2% and also unemployment between 4-6%. Since inflation has been high and the unemployment too low, the Federal Reserve has been raising interest rates (bullish dollar) but now, the market is anticipating an end to rate hikes which means the dollar has been falling.
This dynamic is on display with the USD declining since October, long before inflation started converging towards the target, and despite the continuous interest rate hikes. This USD downtrend has been a bullish factor to coffee prices.
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However, the labor market remains too strong and is becoming a thorn in the side of the Fed's plans, despite inflation being down. Moreover, even though inflation has come a long way down from 10% to 4% in a year, it’s still above the 2% target.
All of this suggests that market was premature in anticipating the end of rate hikes and selling off the USD. This is why the dollar is now rallying to correct this.
How will it affect Coffee
The weakening US dollar was a bullish impact on coffee over the last few months. However, the revival of a hawkish Fed gets in the way here. If 1 or 2 more hikes are planned, this will then offer support for the USD in a 3-month timeframe, which would create downward pressure on the coffee market in the meantime.
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Looking at the last 20 years, when the USD increases by 1 point, Arabica prices tends to decrease by 4.6c. Conversely, when the USD falls 1 point, coffee gains 6.5c by historical standards. Together, this means that for every 1 point $DXY moves, Arabica may experience a contrary move of 5.54c in average.
Considering that the $DXY has been moving sideways inside the 100-106 range for a few months, we think that new hikes will push more towards the upper end of the range, meaning 3.5 points higher maximum. This would then discount 15-20c in Arabica prices for the next 3 months, in the most extreme scenario (which we have low expectations for).
Note that for this to happen, new economic data will need to come in strong, so that the Fed hawkishness is preserved. If the labor market starts to deteriorate, then this scenario will head downhill.
In any case, the Fed hike cycle will end this year despite new hikes, and so given the forward-looking nature of currency markets, the Dollar should retrace beyond 2-3 months. We project it down to 96 in a 6-month timeframe, which would then add a monthly 5-6c to Arabica during this period.
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Yet, it's important to bear in mind that the USD is only one of many factors, that in this case seem to be a mitigating factor of the large bearish view. This market view is based on stock build in destination coupled with weak technicals and an embedded long position that’s long-time vulnerable in Arabica.
Moving Forward & Conclusion
Going forward, the consensus is that the Fed hikes will end this year, and therefore the USD is destined lower, which would be a long-term bullish component in Arabica and Robusta coffee prices. However, there’s a wide divergence to when the Fed will stop hiking, with recent developments suggesting that it will take a couple more months.
Therefore, the data suggests that the macro tide will shift to a bearish influence on coffee over the next few months, as the USD adjusts to the Fed’s hawkish stance. Strong economic data and high inflation will support this view, and so we need to pay special attention to the US labor market data, such as the next Non-Farm Payrolls and the Unemployment Rate. Beyond the 2-3 month timeframe, the Fed’s rate hike cycle will have to end soon, and if the rate hikes have the desired effect it will cool the US economy.
A cooling US economy will require interest rate decreases to boos the economy back up, and this is were the longer term bearish US dollar and bullish commodity price dynamic will come back in.
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