How the Volatile Brazilian Real Contributed to Coffee’s Steep Rally

Arabica Coffee futures are trading around 16-month highs with robusta futures also substantially higher, a surprising fact amid expectations for a bumper crop from top producer Brazil. So what is behind this seemingly incongruent relationship? While there were many factors that went into this event, currency exchange rates had a large influence.

The relationship between currency exchange rates and the price of many raw materials is well known. With most of the world’s commodities priced in US dollars, fluctuating exchange rates with producing countries can impact the amount of commodity these countries are willing to supply, and this in turn influenced their prices. When it comes to coffee, Brazil is the top pro-ducer. In 2015, Brazil produced 43.2 million 60 kilogram bags of coffee. Second-ranked Vietnam produced 27.2 million bags. Volatility in the Brazilian real is a major factor behind the bullish coffee market.

Thanks to Brazil's coffee production could rebound to a record high this year, helped by "fa-vourable" weather in top arabica-growing regions, which could see output soar by up to 58%, according to forecasts from the Conab Agriculture Bureau. Although the agency constantly revises their current estimate, they have the harvest pegged at 49.1 million to 51.9 million bags.

It has been an eventful year for the Brazilian real, with corruption, impeachment, plunging energy prices and general economic malaise causing massive fluctuations in the value of the currency of the summer Olympic Games host country. In the first quarter of the year, the Brazilian real plummeted to an eleven-year low and depreciated almost 20% against the US dollar. While the collapse of the real was a negative for the country’s imports, it was a boon for its exports.

In the first quarter, as the real depreciated against the US dollar, farmers were incentivized to sell their coffee beans. A depreciating real resulted in a decrease in the local cost base, which helped the farmers’ margins. The falling currency also encouraged Brazilian producers with high debt levels looking for cash flow to sell their stocks.In addition, it made the country’s coffee competitively priced. All of these factors resulted in farmers increasing their sales of coffee early in the year, and stockpiles decreased. All of this happened with expectations of an upcoming bumper arabica crop.

So what did this mean for the coffee market? The influx of new supply through Brazilian farmer’s readiness to sell their beans initially put pressure on global prices, but over the course of the year coffee prices have actually increased. The reason for this is that the willingness of Brazilian farmers to export beans in the first part of the year was met with increased demand, and this eroded stockpiles. At the same time, we have seen a major change in the value of the real and now, after increasing their supplies the real has appreciated and farmers became reluctant to continue to supply high levels of beans.

The real has improved so far in the second half of the year, thanks to acting President Michel Temer’s assumption of office last May. Temer’s team has pushed through policies aimed at sta-bilizing Brazil’s economy, and this contributed to the recovering, and strengthening currency. If the real continues to improve famers may continue to remain reluctant about selling their coffee stocks despite robust demand, this could push prices even higher.

Of course, while all of this has been going on speculators have been pouring into the coffee market, exacerbating the commodity’s ascent. When speculators drive-up prices, they can also cause a collapse. So far; however, they have found little reason to sell. According to Commodi-ties Futures Trading Commission data, bets on higher arabica prices climbed to the highest since 2014 in the week ended July 5.

Arabica coffee inventories tracked by ICE are currently sitting around their lowest levels since November 2011. Expectations are that the coffee market will be in its first supply deficit in six years. Even though a bumper crop is expected from Brazil’s upcoming Arabica crop, this has been expected and now, this crop has to meet or exceed expectations or we could see another rapid ascent in prices.

The fluctuating real has impacted prices, but it is important to note that its influence on exports would be nothing if there were no demand for coffee. Global consumption is expected to rise 1.2% in the season that starts in October to a record 150.8 million bags. LMC international is forecasting a 2% increase in demand this year, and another 2% in the following year. At the same time, there are high expectations for Brazil’s maturing arabica coffee crop following two years of drought. Brazilian agronomists now say that coffee farms have fully recovered from the dry conditions, and the upcoming harvest will be large with big screen beans.

Still, the pinch will be felt after a few years of poor harvests, and then an uptick of exports in the first part of the year means that the upcoming crop of Arabica is under significant pressure. The only hope for a retreat in coffee prices is for Brazil’s economy to continue to repair, sending its currency higher, and for few years of healthy arabica crops to help mitigate the damage. It is important to note that robusta has also seen a hefty ascent, with Brazilian exports and bad weather in robusta’s top producing country, Vietnam taking a toll on arabica’s lower quality cou-sin, the robusta bean.