Brazilian Real (BRL) Ripe For Investment

The Brazilian real continues to strengthen against the U.S. dollar, managing to break below the key level of 1.70 and forcing the Brazilian Central Bank to consider foreign …

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The Brazilian real continues to strengthen against the U.S. dollar, managing to break below the key level of 1.70 and forcing the Brazilian Central Bank to consider foreign currency measures to contain further growth. The 1.70 mark had not been achieved since October 2011 and the South American country’s currency performance had officials contemplating a reintroduction of Brazil’s IOF tax on foreign investment as was as a tax increase on derivatives earnings. Analysts outside of Brazil believe the country may implement such measures; however, no one is clear what will result. For more on this continue reading the following article from TheStreet.

The board is set, and the chips are stacking up for foreign exchange and interest rate bets in Brazil.

On the currency war front, officials are growing more bellicose around the dollar/real 1.70 (spot) trench in response to growing market conviction that a sustainable break below the key level is forthcoming.

The government is raising the stakes. The central bank remains at the front line with spot and foreign exchange swap interventions, and the bigger guns are coming out after the USD/BRL currency pair closed at less than 1.70 Tuesday for the first time since October.

Tuesday evening, Treasury Secretary Arno Augustin stated that the sovereign wealth fund is ready to be used to contain BRL strength.

The secretary also reminded markets that the fund’s potential USD buying power is theoretically unlimited. On Wednesday, officials are again warning of more foreign exchange measures. Some possibilities include reintroducing the IOF on foreign equity investment as well as raising the tax on derivatives.

We have no doubts the Treasury is willing to act to stem BRL appreciation, but we are less sure about the odds of it working.

The best that the authorities can do is to slow down the pace of appreciation, in our view.

Inflows are still largely driven by fundamentals (massive FDI numbers) and prospects of continued high carry (even if SELIC falls to 9.00% later this year).

As such, the risk rewards for being short USD/BRL at these levels depends largely on investors’ time frame.

In the short term, BRL will get very choppy until it makes a clean break of 1.70. In the meantime, we think there are better ways to express outright positive emerging-market foreign exchange views. They include the Mexican peso, Polish zloty, ruble, and won.

For a longer-term investment, however, the carry and prospects of gradual appreciation are very favorable.

Despite 200 basis points of easing already and another 150 basis points of easing on deck, implied yields remain high.

The one-month BRL nondeliverable forward implied yield around 9% is still about as high as it was last August, when COPOM (the monetary policy committee of Brazil’s central bank) first started cutting rates. After the 1.70 level, other near-term targets are 1.67 (October 2011 lows) and then 1.65.

On the rates front, markets have all but convinced themselves that SELIC rates will reach 9.00% by the middle of the year, having also fully committed to the short-end receiving rates trade.

By default, this leaves the market in a poor technical position to deal with surprises pointing the other way. Surprises could come in the form of (1) unexpectedly stronger economic data (2) fiscal slippage; or (3) a change in communication showing greater concerns about inflation, implying less or slower rate cuts.

Since (1) and (2) are far (far!) more likely than the (3), we think the best way to position for the risk of a surprise is through curve steepening trades. This is especially true because (1) and/or (2) may not trigger the (3).

We update our end of cycle SELIC rate expectations from last year’s forecast of "9.50% with a lower bias" to 9.00%-9.25% in light of recent data and official communication. The next COPOM meeting is March 6/7, with markets looking for another 50-basis-point cut to 10%.

The communication emphasis will change somewhat, but the end result is basically swapping one set of dovish arguments for another. To keep up the dovish tone, central bank President Alexandre Antonio Tombini seems to be relying less on external risks and more on the view that Brazil’s "neutral interest rate" are declining.

Turning to fundamentals, lending data released Tuesday showed that there is little to get excited about: New loans to corporates fell while those to consumers rose, but overall lending decelerated from 19.0% in December to 18.4% in January.

The data strengthen the case for further easing, especially by loosening macroprudential measures.

Ahead of the COPOM meeting, we will get a look at fourth-quarter GDP, February PMI and trade and January industrial production.

All are expected to show continued slowing, which will underscore COPOM’s dovish stance. On the fiscal front, the government posted a higher-than-expected budget surplus of 20.8 billion reals (vs. expectations of 18.8 billion reals).

We think the government is serious about carrying through fiscal tightening to allow more space for monetary easing, but we are not yet convinced they can do so.

Recall that the minimum wage will increase substantially this year and that President Dilma Rousseff’s industrial policy initiatives come with a hefty price tag.

This article was republished with permission from TheStreet.

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