As markets gradually move beyond pressures from energy inflation, geopolitical tensions, and persistent central bank tightness, a new potential source of volatility is emerging in the Pacific: El Niño.
Introduction
Earlier this month, the National Oceanic and Atmospheric Administration confirmed that El Niño conditions have developed across the Pacific Ocean. Early projections indicate this could evolve into one of the strongest events in decades, with impacts extending well beyond weather patterns.
El Niño is a recurring climate phenomenon that appears every few years when trade winds across the tropical Pacific weaken. As a result, warm surface waters that are usually pushed toward Asia and Oceania shift back toward the Americas. This disrupts global weather systems, often causing heavier rainfall in parts of the Americas while bringing hotter, drier conditions to regions such as South and Southeast Asia, Australia, and Southern Africa. These shifts can lead to droughts, heatwaves, or excessive rainfall, all of which can damage crop yields, disrupt planting cycles, and strain global food supply chains. Following a period where inflation has been driven largely by energy costs, food-related shocks may become the next major inflationary pressure.
A Strong El Niño Is Taking Shape
Research on El Niño’s macroeconomic effects consistently highlights its influence on commodity markets, particularly agriculture. The main transmission channel is through food prices, with multiple studies suggesting a clear link between ENSO cycles and commodity inflation.
Federal Reserve research estimates that nearly 20% of fluctuations in commodity-price inflation can be attributed to ENSO patterns. In a typical El Niño event, real commodity inflation may rise by around 3% over a six- to twelve-month horizon, with agricultural commodities experiencing the most significant impact. Studies by Cashin, Mohaddes, and Raissi further suggest global non-energy commodity prices can increase by approximately 5%, with effects lasting six to sixteen months.
Weather disruptions reduce crop yields, degrade quality, and delay transportation, tightening physical supply conditions. Agricultural prices tend to respond first, and rising input costs eventually feed through to broader food inflation. This can also weaken local currencies, increase imported inflation, and reduce central banks’ flexibility to lower interest rates.
Two key patterns stand out.
First, the growth effects differ significantly across countries. Economies such as Australia, India, Indonesia, Chile, parts of Southern Africa, and the Andean region typically experience negative output shocks when El Niño disrupts rainfall and agricultural activity. In contrast, the United States and some European economies may see a smaller negative impact or even modest gains. In South America, particularly Brazil and Argentina, segments of the soybean supply chain can benefit from increased rainfall conditions.
Second, inflation responses are uneven across regions. The effect is most pronounced in countries where food accounts for a large share of the consumer price index and where exchange rate pass-through is strong. In these economies, rising food and energy costs can push up inflation expectations, weaken domestic currencies, and intensify imported inflation pressures. As a result, central banks—especially in emerging markets that rely on commodity imports—often face limited scope to reduce interest rates.
The euro area is relatively insulated. Research from Banco de España suggests that El Niño episodes have historically lowered euro-area inflation by about 0.3 percentage points after one year. This is mainly due to composition effects and the Common Agricultural Policy, which helps buffer the transmission of global food price shocks to European consumers.
The Commodity Shock
Commodity markets typically move ahead of official inflation data, as agricultural prices are driven by expectations that can shift rapidly with changes in rainfall, temperature, and harvest conditions. This year, weather-related risks are emerging on top of already elevated input costs. Farmers continue to face high fertiliser and diesel expenses following prolonged energy-market stress and geopolitical disruptions. The World Bank projects global commodity prices to rise by about 16% in 2026—the first annual increase since 2022—driven mainly by energy and fertiliser costs. While agricultural prices are expected to decline under baseline assumptions, El Niño represents a clear upside risk to that outlook.
Historically, El Niño episodes have tended to support soft commodity prices. Products such as cocoa, coffee, sugar, palm oil, cotton, and rice are highly sensitive to rainfall patterns in tropical regions. However, the actual price response varies depending on inventory levels, regional weather conditions, and substitution effects across crops.
Cocoa is particularly vulnerable. Ivory Coast and Ghana together account for roughly half of global cocoa production. Strong El Niño events have often reduced output in these regions, either through drought conditions or through a combination of excessive rainfall followed by disease pressure. The most recent cycle illustrated this clearly: heavy rains initially increased disease risk for cocoa trees, followed by extreme heat and dry Harmattan winds that further damaged already weakened crops. As a result, cocoa prices surged dramatically in 2024, at one point approaching or exceeding USD 12,000 per metric ton, making it one of the most volatile commodity stories of the year.
Palm oil and cotton also carry significant exposure to weather conditions in Asia, particularly in Indonesia, Malaysia, and India. Any weakness in the monsoon season can quickly alter supply expectations for these crops.
Coffee exposure is mainly concentrated in robusta production, with Vietnam and Indonesia accounting for around half of global supply. El Niño typically brings hotter and drier conditions during key growing stages. Arabica behaves differently: Brazil may initially benefit from reduced frost risk, but later-season heat and dryness can still threaten yields.
Sugar is somewhat more resilient. A weaker monsoon in India and Thailand can support prices, although India may offset part of the production loss by diverting ethanol feedstock back into sugar output.
Rice is highly sensitive to monsoon performance. A weak rainy season across Asia can quickly reduce output expectations and heighten food security concerns, especially in countries where rice is a dietary staple.
Corn is influenced more by regional weather patterns than El Niño alone. While dryness in some regions can support prices, the overall signal is mixed because other growing areas may experience favorable conditions.
Soybeans present a more complex picture. While El Niño can create stress in certain regions, improved rainfall in Brazil and Argentina may offset losses elsewhere, making price effects less straightforward compared with crops like rice or palm oil.
Natural gas stands out as the main exception. A milder winter in the Northern Hemisphere typically reduces heating demand and puts downward pressure on prices. However, in 2026 this seasonal weakness may be partially offset by broader energy-market tensions linked to geopolitical risks in the Strait of Hormuz.
Looking ahead, the Indian monsoon is a key near-term catalyst. Rainfall between June and September will be critical for cotton, sugar, rice, and palm oil markets. A normal monsoon would likely contain much of the El Niño-related risk, while a significant shortfall would reintroduce strong upside price pressure.
Finally, there is a mismatch in timing between futures and physical markets. Weather forecasts are still influenced by the “spring predictability barrier,” a period when El Niño models are less reliable before summer data becomes clearer. As a result, futures markets may begin pricing in 2026–27 weather risks well in advance, while physical markets remain anchored to current inventories, crop conditions, and near-term supply-demand fundamentals.
Implications for Financial Markets
In equity markets, potential beneficiaries typically include fertiliser manufacturers, agricultural input suppliers, and commodity-exporting firms. In contrast, companies involved in food processing, beverages, and other downstream users of agricultural commodities may face margin compression due to rising input costs. The insurance and reinsurance sectors could also come under pressure from increased claims linked to extreme weather events such as floods, droughts, and wildfires. While overall equity performance may be dampened by supply-chain disruptions and agricultural volatility, the impact is likely to differ significantly across regions and sectors.
From a foreign exchange and emerging markets perspective, countries that rely heavily on food imports and have high inflation pass-through tend to be most vulnerable. These economies may experience currency depreciation and tighter monetary policy conditions. On the other hand, commodity-exporting nations could benefit from improved terms of trade. Overall, a strong El Niño event would create meaningful cross-asset implications, favoring selective exposure to commodities, inflation hedges, and careful allocation across duration, emerging market assets, and sector positioning. Close monitoring of updates from agencies such as NOAA, the WMO, and commodity price signals will be important for positioning decisions.
Conclusion
Even a severe El Niño is considered a secondary risk compared to the current energy-driven shock originating from the Strait of Hormuz, which remains the dominant force shaping commodity and inflation dynamics. Its importance lies in its role as an additional upside risk to food inflation and emerging market pressure.
The most important near-term variable to watch is the Indian monsoon through September, which will act as a key turning point. A normal monsoon would help contain much of the weather-related risk, while a significant shortfall could transform the current uncertainty into a clearer and more tradable disruption in soft commodity markets.
THE ETERNAL SOVEREIGN 