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The strength of the real is often the most decisive factor in prices, which means a recent rally may be running out of steam.

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October 29th, 2018

What drives commodity prices? Supply and demand, or currency movements?

For once we’re not talking about the U.S. dollar, a swing factor for the price of oil, industrial metals and gold. In agricultural markets, the Brazilian real is a key proxy for the value of coffee and sugar — so keep an eye on the cost of your pumpkin spice latte for shock waves from the election Sunday of far-right candidate Jair Bolsonaro in Brazil’s presidential contest.

Both crops had been struggling recently amid gluts in supply. The main No. 11 sugar contract hit a 10-year low on Aug. 20. Coffee was in an even worse state, with arabica beans — the fragrant, higher-quality variety mainly grown in Brazil — falling to its lowest level since 2006 on Sept. 18.
Back From the Dead

Sugar and coffee prices have rallied over the past month

Source: Bloomberg, Bloomberg Opinion calculations

Note: Rebased. Dec. 31, 2016=100. Contract prices are quoted in cents per pound -- they've been converted to fit on a single axis.

Bolsonaro’s strong showing in first-round elections Oct. 7 drove a rapid reversal of that dynamic. Front-month arabica futures have risen 9.8 percent since, and sugar has gained 9.5 percent — in both cases outpacing the appreciation in the real itself, which strengthened 5.5 percent against the dollar over the period. (The effect on soybeans, another crucial Brazilian crop, has been more muted, since the U.S. is the swing producer and its output is influenced by the trade war with China.)

Hedge funds have been busy closing out their short positions to avoid getting caught by these rising prices. Their net short position in coffee, which hit a record of 109,159 contracts last month, has narrowed to just 34,730 as of last Tuesday. In sugar, it’s flipped back into long territory for the first time in almost a year, after touching a near-record low of 157,481 short in September.

There’s a straightforward reason for this. When there are about 4 reais to the dollar, as was the case in early September, a typical $200, 60-kilogram (132-pound) bag of beans would fetch its Brazilian grower 800 reais. When the exchange rate is 3 reais, that falls to 600 reais per bag. As a result, a stronger currency encourages farmers to withhold or store lower-priced product, tightening the supply-demand balance and raising prices.
Pick Me Up

The net short position by managed money funds in coffee and sugar futures has narrowed or vanished

Source: Commodity Futures Trading Commission, Bloomberg

The factors that drove coffee’s slump in 2018 haven’t really changed. The crop currently being harvested will be the largest in history, Brazil’s government-purchasing agency Conab said last month, up by a third from the previous year at just shy of 60 million bags. In global terms, supply in the year through September exceeded demand by about 2.58 million bags, according to the International Coffee Organization.

Next year’s harvest in Brazil will almost certainly be smaller — coffee follows a 24-month cycle of off-years and on-years. But even then, rains in key growing regions have been supporting flowers that will develop into harvestable beans in the middle of next year, according to Cepea, an agricultural research center.

Against that somewhat bearish picture is the historically strong correlation between coffee prices and currencies, which often seems the most decisive link. Here, it’s worth considering whether the Brazilian real can strengthen much further. The consensus among analysts for the 2019 calendar year is at 3.6750, slightly weaker than its current level, according to data compiled by Bloomberg. The median forecast for that year’s gross domestic product growth has fallen to 2.3 percent, hardly a bullish sign for the currency.

Right now, covering shorts and the vagaries of the forex market have sent coffee and sugar surging. Like all stimulants, though, that initial buzz has a nasty habit of wearing off.

 - Bloomberg.

See Also: Coffee, Cocoa, Cotton, Orange Juice, Sugar