"Perfect Storm" Strikes Softs, But Are Coffee Specs Due For A Wake-Up Call?

With massive coffee and sugar inventories already weighing on the softs market, the reinvigorated emerging market crisis has created a “perfect storm,” encouraging local producers in countries such as Brazil and Colombia to boost sales which fetch dollars in return, said Julio Sera, risk management consultant for INTL FCStone in Miami.

In fact, the Bloomberg Softs Subindex, which measures returns for those commodities plus cotton, tumbled to a record low...

However, with speculative positioning in sugar and coffee at or near all-time record net short, the worst could be over. (the softs are a close proxy for emerging markets, but with elevated covering risks). As Bloomberg Intelligence details below:

Further declines in the softs are highly dependent on a weaker Brazilian real and sugar. The worst is likely over for sugar, down over 30% in 2018. Recovery is highly dependent on similar weakness in the real, down about 20% vs. the U.S. dollar this year. Short sugar has been the proper position, but with prices near a 10-year low at key 10-cents-a-pound support and net short positions leading all major commodities, covering risks are quite elevated.

Sugar futures' managed-money net positions are close to being the most short in the database since 2006 at 150,341. Next in line is soft companion coffee, at 104,336 as of Aug. 28. Brazil sugar supply estimates from CONAB, Brazil's food statistics agency, are the lowest since 2009. Supply is unlikely to increase until prices do.

Short has been the right position in coffee futures, but covering risks are about as elevated as they get. Prices dipping to a 12-year low in August probably reflect about the worst of the substantial increase in Brazilian supply and the currency's drop. Net managed-money short futures positions have consistently set records in 2018. Recently, their velocity has accelerated at the greatest pace on record since 2006. Net shorts have increased over 66,000 since the end of May, the most in any similar period.

New shorts are weighing on prices but are ripe for cleansing.

Pressuring prices are the real's 20% decline vs. the dollar in 2018 to Aug. 28 and the record increase in Brazil coffee production. CONAB estimates production climbing to 20% above the five-year average, the most in the database since 2001.

So is the worst really over for softs and/or EM FX? The extreme correlation of the two will need to shatter if so.