Tough choices ahead for Brazil

Few investors, if asked at the beginning of the year to name the best performing currency by the end of the first half, would have picked the Brazilian real. And yet that is the situation in which we find ourselves.

Brazil real
Source: Bloomberg

The rise in the currency has been driven by a number of factors. Firstly, we have the weakening of the US dollar and a concomitant rise in commodity prices. Expectations of a move in interest rates by the US Federal Reserve have been one of the driving factors of market moves over the past year, but in recent weeks the American central bank had begun to turn dovish (that is the governing committee was looking to ease policy).

It is likely that the Brexit vote – the UK’s decision to leave the European Union – will only accelerate this move. Developed market central banks (e.g. the Fed, European Central Bank, Bank of Japan and Bank of England) have all shifted positions of late, looking to boost their economies through easing. As a result, emerging market economies have seen a degree of strength as money flows back to areas such as Brazil that offer a better yield.

In addition, Brazilian assets have become much more popular this year, based on the idea that acting president Michel Temer, who took over from Dilma Rousseff after the latter was impeached in December and then suspended in May 2016, would begin to enact fiscal policies designed to bring Brazil out of its worst recession in a century. So far there is not much sign of these measures, but for now the mere hope of a change in policy, combined with weakness in developing markets and the changing expectations for Fed tightening, have helped to drive the real higher.

Having risen by around 18% so far this year against the US dollar (as of 6 July), the question now is whether there is more to come or whether the rally has run its course. The rally has seen a rush of upgrades to forecasts by investment banking analysts, but this is more a function of hindsight rather than a concrete expectation of more to come. 

The problem for Brazil is that the fate of its currency is broadly out of its own hands, with the real decisions made in Washington by the Federal Reserve. The Brazilian central bank had been expecting the Fed to raise rates at least once this year, but that now seems an increasingly unlikely proposition. The bank had hoped that a strengthening US dollar would take some of the heat out of the real, providing breathing room for exporters, but that hope has been dashed. Some form of easing is likely, with interest rates the most likely policy tool for now.

Currently, Brazil’s interest rate stands at 14.25%, while the ten-year bond yield is around 12.25%. The interest rate has moved from a low of around 7% in 2013 to its current level, as the central bank looked to combat inflation. However, now it faces calls from Brazilian business to cut rates to stimulate the economy. The appointment of Ilan Goldfajn, a former Wall Street economist, to head up the central bank is a signal that more market-friendly policies may be enacted. Unfortunately for Brazil, the Fed’s tiptoeing away from interest rate increases will likely only encourage funds to head to emerging markets, including Brazil, providing a counterweight to looser monetary policy.

The attitude of FX markets has been to ‘sell the rally’ in the USD/BRL rate since the beginning of March, and so far there seems little expectation that this approach will change. If the mighty Bank of Japan finds it difficult to compete against the Fed where monetary policy is concerned, it looks likely that Brazil’s central bank will find it even harder. 

This piece is part of our series on Rio 2016. For expert analysis, Brazilian trading opportunities, and more, take a look at our Rio 2016 page.

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