Brazilian real troubles far from over
The decline of the Brazilian real to a nine-year low this week seemed to mark a nadir for a currency buffeted by economic and political concerns. Analysts say, though, that things could get worse before they get better.
Brazil’s real dropped to the lowest level against the dollar since 2005 after leftist president Dilma Rousseff was re-elected at the weekend, amid speculation Latin America’s largest economy will remain stalled for the foreseeable future. The currency fell nearly 3% early on Monday to 2.5394 against the dollar, the worst performance in the world that day.
Short-term implied volatility, a reflection of demand to hedge or take risk on the currency, rose to more than 21%, the highest level among the major currencies. The Brazilian real has lost around 56% of its value against the dollar in the past three and a half years.
Rousseff won 52% of the vote in the closest presidential election for decades, with voters split between populist policies and increasing concern over the economy, fuelled by a widening fiscal deficit and soaring inflation. “On the face of it the result of the election spells more bad news for the currency,” says Eric Viloria, New York-based vice-president and currency strategist at Wells Fargo Securities. “However, one thing that could offer some short-term support would be if US rates were to stay lower for longer, which would have a dampening impact on the dollar.”
The US Federal Open Market Committee meeting this week is the next step on an inevitable journey toward higher US benchmark rates and the end of the carry trade that has supported investment flows into emerging markets since the financial crisis. However, the timing of any rise remains uncertain, amid global economic headwinds that have led investors to buy safe-haven US Treasury securities in recent weeks.
“It may be that the dollar has come too far too fast,” says Viloria.
Signs of short-term support for the real were apparent in the Commodity Futures Trading Commission’s Commitments of Traders report last week, which indicated that 83% of traders in US dollar/Brazilian real financial futures were short the dollar against the Brazilian currency, the biggest short position in the market.
Futures markets are equivocal over the timing of any rate rise, with fed funds contracts indicating a 63% likelihood the Federal Reserve will raise interest rates by its December 2015 meeting.
Fed members are split, with doves such as Federal Reserve Bank of New York president William Dudley saying on October 6: “It’s still premature to being to raise interest rates” and hawks such as Federal Reserve Bank of Philadelphia president Charles Prosser on October 16 opining that he would “prefer that we start to raise rates sooner rather than later”.
From a Brazilian point of view the better Fed course would be less and later, because that would give the real a chance to recover and offset some of the risks to the Brazilian economy, such as inflation, the core measure of which was 6.62% in the 12 months to mid-October. That’s slightly below the three-year high posted in September but still above the 6.5% ceiling of the government’s target range.
Another potential short-term boost to the real is the central bank's substantial foreign-currency reserves, which stand at around $377 billion (16% of GDP). The central bank has been using reserves to offer US dollar swaps, which act as a brake on the decline of the currency, and could do more.
However, Brazil’s problems go deeper than swap market positions. Weak fiscal numbers in August and September point to a rising likelihood that the government will be unable to reach its 1.9% surplus target, according to analysts at Morgan Stanley. Athough the new administration might compromise with some fiscal tightening in the coming weeks, perhaps cutting funding from its many social programmes, it is unlikely to overturn a deficit of 4% of GDP, the highest since November 2009.
“The FX market is probably going to be sceptical of the new government’ ability to cut the fiscal deficit, and in fact it’s more likely the government will go back to using fiscal stimulus and public-sector lending to try to boost the economy,” says Felipe Hernandez, a Latam FX strategist at Morgan Stanley in New York. “Our concern is that by continuing to lend below market levels it erodes the influence the central bank can have on inflation and increases the amount of credit risk in the public-sector banks.”
Still, says Hernandez, the real might bounce in the short term. “Following the election there is going to be a sense of greater stability and to be honest the initial sell-off was not as big as we were expecting,” he says. “There will probably be some cabinet changes and policy adjustments which may have a positive effect on the real, especially in a global environment more favourable for risk assets.”
Whether or not that environment remains favourable might depend more than anything on whether Fed doves or hawks win the day.