On a day-to-day basis, the prices of major cash crops such as corn, soy and wheat show almost no correlation to day-to-day movements in the values of currencies of agriculture-producing countries versus the U.S. dollar. For example, since 2011, day-to-day changes in the Brazilian real correlated at 0.12 with movements in corn prices. The Russian rouble’s day-to-day moves correlated at just 0.05 with day-to-day movements in hard red winter wheat. Does this mean that there is nothing for American farmers to be concerned about should the value of these currencies continue to fall?
While currency moves have little apparent short-term influence on the prices of agricultural goods, they do impact the cost of production over longer periods of time, meaning over months and years. A decline in a country’s currency immediately lowers its relative cost of labor. It also reduces the cost of property taxes, loans and other items denominated in the local currency. While a currency devaluation does not insulate farmers from global factors that determine (or at least influence) prices such as the cost of farm equipment, fertilizer and energy, costs that are determined purely at the local level probably account for about half of the cost of running a farm. As such, a fall in the local currency increases competitiveness of domestic farmers.
During commodity bear markets, prices often fall to the level of the cost of production. This is the market’s way of shaking out inefficient, costly producers, reducing the level of inventory and bringing markets back into equilibrium – an extremely painful process for producers, to be sure. The impact that weaker emerging market currencies may have over the long run is to lower the threshold (or floor) to which agricultural goods prices can fall in a bearish market. Farmers in places like Argentina, Brazil and Russia, where currencies are weakening, will be partially or mostly insulated from these negative effects. Producers in places like the United States, whose currency is being lifted by the aggressive rate rises by the U.S. Federal Reserve, will not.
As we have highlighted in other research reports concerning the dollar-euro exchange rate, the U.S. currency is caught in a tug-of-war between a tightening monetary policy, which is pulling the dollar higher, and a deteriorating fiscal situation which is dragging it lower. With tax reform and spending legislation set in stone for the time being, markets have been focusing more on monetary policy, which is still malleable and is at the discretion of the U.S. Federal Reserve (Fed), which, wisely or not, appears determined to further tighten policy substantially.
Past Fed policy tightening cycles may have played a role in setting off the emerging market crises. Most famously, the 1979-81 tightening cycle almost certainly helped to set off Latin America’s decade-long debt crisis during the 1980s. Following the Fed’s 1994 doubling of short-term rates, the Mexican peso collapsed. A small Fed hike in March 1997 combined with the accumulated rate hikes in 1994 may have helped trigger the Asian financial crisis of 1997-98 and the Russian debt default in 1998. The Argentine and Turkish currency crises occurred within 12 months of the end of the Fed’s 1999-2000 tightening cycle.
During the period of near zero rates from December 2008 to December 2015, the world became accustomed to inexpensive financing from the U.S. One rate hike in 2015 and another in 2016 didn’t change this picture much. However, three hikes last year plus one thus far in 2018 (and several more expected) are changing the financing picture. If the Fed hikes as expected in June, the cost of financing from the U.S. will go from 0.125% a few years ago to nearly 2%.
It’s too early to call for a generalized emerging market currency crisis such as those during the 1980s or 1990s. That said, if one does materialize, it could be bad news for U.S. farmers whose goods would suddenly become much more expensive for foreign buyers and whose foreign competitors could gain a substantial cost-advantage via currency adjustments.
The good news for American farmers is that inflation in Argentina, Brazil and Russia is much higher than in the U.S. and this could generate some upward wage pressure in those markets which in turn could offset some of the farm benefits of a weaker currency. For example, the Brazilian real and the Russian rouble don’t look nearly as low versus the U.S. dollar when adjusted for the cumulative impact of the inflation differential between the two currencies. Here we use the interest rate differential embedded in rolled futures contracts versus spot prices as a proxy for the cumulative inflation differential (Figures 5 and 6).
But the currencies have fallen a long way versus the U.S. dollar, even after being adjusted for inflation, to the benefit of their domestic producers and to the disadvantage of U.S. farmers. That said, higher rates of inflation buffer some of these effects.
For the moment, options markets are pricing much greater upside risks to crop prices than downside risks. Traders are apparently more concerned by declining inventories and the potential for poor harvests than they are about the incipient crisis in emerging markets and the possibly bearish consequences for crop prices. There are two possible interpretations for this phenomenon:
- Options traders are broadly correct in that upside risks to prices exceed downside risks.
- Out-of-the-money (OTM) put options on corn, soy and wheat are trading inexpensively if upside and downside risks are more evenly balanced.
The degree of skewness in options markets is remarkable. As of May 23, some cases of OTM calls traded for 40-50% more than similarly OTM puts across the major cash crops (Figures 7, 8 and 9). While it is possible that this pricing reflects the true distribution of risks, those who are hoping to see upside price risks had better hope that there is no generalized emerging market currency crisis on the way. The last time that there were widespread problems, during 1997-98 Asian and Russian crises, prices of corn, soy and wheat fell by 35-40%. The global situation is very different this time around but, at the very least, weaker currencies in Argentina, Brazil and Russia could lower the floor to which crop prices might eventually decline to in the event of a renewed bear market.
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By: CME Group