A Strange Brew: Why Coffee, Gold Are Acting Like Related Commodities
The two are trading with a 96% positive correlation, but once we filter out an odd anomaly and let the markets percolate a bit, we could see buying start to dry up.
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We pointed out in a recent newsletter an odd relationship between live cattle, crude oil, and corn. These three futures contracts moved in lockstep, as if they shared the same supply/demand graph. We assumed this was a sign of a market anomaly caused by fund or algorithm buying intending to hedge inflation. We have since seen the correlation decouple; crude oil was the first rally to crack, then live cattle followed, and we believe corn will soon be on its way. While there were legitimate reasons to be bullish on all three of these assets, unnaturally high correlations are a telltale sign that the price action was momentum-driven instead of fundamentally driven. Such moves are generally unsustainable once all the buying power is deployed and the markets have to stand on their own two feet.
We’ve spotted a similarly odd relationship between coffee and gold. If there is a logical reason for coffee and gold to be trading with a 96% positive correlation, we would like to hear it. To us, this doesn’t pass the smell test. We suspect both markets are at, or near, unsustainable pricing driven by narrative buying. Of course, even if we are right about this assessment, it doesn’t mean the buying dries up today; it might take weeks or longer.
Funds and Speculators Are Already Aggressively Long both Coffee and Gold Futures
Markets can overshoot reality in a world of electronic trading and government-subsidized liquidity. For years, we have witnessed excess funds sloshing around the economy, left-over from the pandemic stimulus. This, along with indulgent government spending, has pushed asset prices with arguably little value to astronomical prices (“crap” coins named after the President, nonfungible tokens, meme stocks). Coffee and gold are not on the same plain as the assets above, but speculative fervor has benefited the assets. As a commodity broker, I often hear complaints about speculators pushing futures markets to unreasonable prices. This is a fair argument in the short run, but in the long run, it eventually comes down to math. Eventually, the price discovery process works through the chaos to find rationality. According to the Commitments of Traders report, there are more large speculators and fund dollars long coffee now than ever before. Looking back over the last 20 years, this contrarian indicator has batted 1,000%.
The gold market is also seeing runaway bullish sentiment and aggressive buying. We have been suggesting this gold market looks and feels a lot like the 2011 metals market. The recent new high in gold decouples the similarities slightly, but we think the overall outcome will be comparable. Unlike coffee, which has reversed bull markets near speculative buying peaks, gold prices tend to soften after speculators and funds have started lightening up. Nevertheless, once these groups of investors become wildly long the market, the rally has generally achieved the majority of the move.
They say a picture is worth a thousand words, so let's refer to the charts to see where these commodities have been and guess what might come next.
Monthly Coffee Chart
Coffee futures have not only gone parabolic, but they are arguably vertical. The Relative Strength Index on a monthly chart is approaching 85, an all-time high for the indicator in this particular commodity. Further, such an extreme reading on a monthly chart has only been reserved for the most asinine of rallies. In other words, it is rare. It has also been unsustainable in commodities. Yet, even if that proves to be accurate, emotional markets have no limits.
The 2021/2022 coffee rally seems like child’s play compared to this one, but it eventually shaved a dollar a pound off the price of coffee before making another run. There are calls for 500 to 700 coffee; I do not believe in this outcome, but even if we see those levels, a 25% to 50% correction is par for the course. Nobody said the commodity business is easy.
Monthly Gold Chart
It took a while, but investors have finally concluded that Bitcoin and gold can go up together. It is no longer assumed that one is a substitute for the other or vice versa. However, as much as I fail to understand the value the marketplace has assigned Bitcoin (not the obviously valuable technology, but this particular coin itself), I will say there is some real value in the electronic liquidity of a non-tangible asset. Few fail to realize just how difficult it is to sell physical gold. I’ve spoken to individuals who have incrementally bought coins or bars for decades only to find that when the time comes to cash in on their wealth, it is expensive, inconvenient, and even costly to do so. For this reason, I’ve always advocated for gold futures over holding gold bars in your hand. Rolling over expiring contracts isn’t ideal, but neither are storage costs, delivery costs, and massive price slippage to liquidate.
The RSI on a monthly gold chart is near 80, which portrays an overheated market. This alone isn’t enough to turn prices, but the fact that speculators have likely already bought what they can and will buy, and interest-yielding Treasuries will attract safety inflows, should start working against the metal.
Bottom Line
It is no secret that electronic and algorithmic trading has changed the landscape. Markets move faster and further than ever before on less news, which can also be attributed to unprecedented growth in the money supply. Nevertheless, macro market cycles persist despite the higher volatility. As long as this continues, high commodity prices will eventually cure high commodity prices, and high interest rates will eventually be a drag on gold.
