Brazil is in an inflection point, as its Central Bank (BCB) is expected to reduce interest rates for the 1st time after 2 years of hikes, while a tax reform is close to being approved. This could mean a revaluation for the Brazilian Real which in turn could have a major impact on coffee. In our view, the long-term net effect of these changes leans bearish for the coffee market and would offset bullish impact from the USD.
The BCB policy is essentially dovish and would devalue the BRL over the next several months. This would attract new crop sellers (or at least, make current low prices relatively more attractive) by improving KC prices in BRL terms. However, the tax reform implications are far more ambiguous, perhaps adding some small bullishness.
In this article, we will present the basis of our standpoint, offering a comprehensive context into Brazil’s macroeconomic landscape, focusing on how currencies and politics should influence coffee moving forward.
Why the BRL Affects the Coffee Market
Although commodities are priced in US Dollar terms, Brazil is by far the world’s largest coffee supplier. This ultimately means that changes in its currency quotation (the BRL) affect the selling of Brazil coffees, and therefore their availability. Thus, if we can predict the BRL, we can anticipate how it will affect the Arabica market (BRL/KC sharing a 53% last 2 months).
The Brazilian exporter and farmer revenue is measure in BRL terms. Therefore, if the BRL is strong against the USD (e.g., if 1 USD buys 2 BRL), they receive less revenue for their coffees and tend to restrain deals, whereas if the BRL is weak (e.g., if 1 USD buys 10 BRL), they tend to receive higher revenues and consequently release more coffee.
As a result, BRL and coffee share a direct correlation, as described below:
Monetary policy is a large influence on the BRL. For Brazil, monetary policy is set by the BCB (Brazil Central Bank), although the Real is also influenced by the Fed (as the currency is often priced in Dollar terms). In general, interest rate hikes are bullish the BRL and rate drops are bearish.
Over the course of the last 2 years, Brazil experienced a major hawkish monetary cycle, that lifted interest rates from 2% (mid 2021) to 13.75% (mid 2023). This wide increase created some sweet advantages to carry trade strategies that lifted the BRL to 1Y highs. However, the markets are now pricing 95% chance of a rate cut for Aug 2nd as the starting point of a cumulative -1.75bps cut this year.
Note: Carry trade = borrow at a low interest rate economy and re-invest in a high interest rate economy
BRL landscape & its Context for Coffee
The BRL has been rallying since March (bullish for coffee), but now we anticipate that the rate cuts will undermine the BRL strength (bearish for coffee), since this strength is heavily based on the carry trade, which will start becoming less attractive as rates descend.
When analyzing Brazil’s interest rates path, we first need to understand why cuts are underway, and that speaks to inflation. The BCB has a mandate of maintaining inflation at 3.25%, while it is now at 3.9%. This means inflation steadily reduces towards target while the economy cools down, and so the requirements for a dovish phase are aligned, especially considering that rates have been at 13.75% for quite a few months now.
While Brazil contemplates a rate cut, the US Fed is projected to hike another +25bps next week, and so the net change in rate differential advocates against the BRL. This is especially true when considering the funds' positioning on the BRL, which is max long, and therefore vulnerable to liquidation.
National funds in Brazil are at a 5Y max long position on the BRL, whereas foreign funds (trading at the CME exchange) are at the max of the last 1.5Y in favor of the BRL. In both cases, most positions were added through Mar-Jun, which coincides with the BRL rally. Ultimately, this means that the bulk of long positions lies around 4.9-5.0, and so if the BRL approaches this area, funds will start liquidating and pressure the Real.
There are reasonable chances of fund liquidation happening (bearish BRL & coffee) if the BCB cuts interest rates in August. However, we project a USD downfall (based on a dovish Fed phase anticipated) as a mitigating factor. Hence, we expect the BRL to lose steam, but unlike to sell off heavily (i.e., to 5.3-5.5).
Implications to Coffee
The BRL should retrace back to 5.0-5.10 range over the next few months, which increases revenue to exporters/farmers, somewhat favoring liquidity of new crop coffees (bearish feature), which have been unusually slow for the period. However, even though the BRL reduces, the revenue incentive should be light, as prospects for futures and physical prices are negative.
Conversely, if coffee prices rally and stay strong as the BRL melts, it would strongly play in favor of liquidity of new crop Brazil’s, but we think this is a low chance scenario, given the ongoing harvest, upcoming October crops and absence of weather problems (such as a frost).
Tax Reform & Its Impacts on Coffee
Meanwhile, there’s a tax reform package being passed in Brazil. It's unclear what the impact is going to be for coffee, but we can lay out some potential outcomes, which we think are more bullish than bearish. This reform leaves an open door for taxing agricultural inputs, and so if input taxes become part of the bill, the Brazilian producers would need to increase their selling prices.
Additionally, if the reform makes the fiscal landscape stronger, it will come as a supportive component for the BRL. However, it’s premature to say one way or another. The reform has just passed Congress and still needs approval by the Senate to turn effective, while amendments to the text are not discarded.
Conclusions
The BRL outlook is somewhat favorable to coffee producers, and so it should encourage selling and manifest as a bearish component to prices. However, there are other factors at play that could potentially affect this outlook, notably the USD and KC quotations.
If Arabica continues to be weak (which aligns with our view), then this BRL retracement could stimulate selling, which has been subdued. Similarly, if Arabica rallies, then selling pressure from exporters and farmers should come in strong, which would consequently contribute to pushing the market down again.
We do also have to watch for the reversal scenario, if Brazil’s economic data trends reverse, and the BCB surprises in its next decisions, or if taxes are placed on farming inputs in the future, this could add bullishness to the coffee price equation.
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