FX Watch – Near term risks for BRL

by: Georgette Boele

  • The BRL rallied strongly between November 2016 and February 2017
  • Then a period of consolidation followed…
  • …which came to an abrupt end because of a sharp deterioration in Brazil’s sentiment following the recent political scandals
  • Politics will continue to weigh on the BRL in the near term…
  • …and USD/BRL could rally towards 3.5…
  • …before recovering later in the year because of dollar weakness
170622-FX-Watch-BRL.pdf (100 KB)


In the period November 2016 to mid-February 2017, the Brazilian real rallied by more than 13% to a low in USD/BRL of just above 3.04. This was a period when the CRB commodity index moved higher, the US dollar came under pressure, the rally in US Treasury yields came to a halt, investor sentiment towards emerging markets was constructive and the local stock exchange (Bovespa) rallied strongly. The central bank in Brazil cut rates aggressively to support the economy and  the stock of outstanding FX swaps diminished (graph below on the left).

The substantial carry on the Brazilian real attracted investors searching for yield. This despite the ongoing political uncertainty. Investors ignored most of the news as there were political risks elsewhere (the US, UK eurozone). Moreover, investors are aware that if they position in Brazilian assets, political uncertainty remain/ a risk. Investors tried several times to push USD/BRL towards 3.0, but they failed. From the moment that the rally in the real has come to a halt, economic news and headlines of political scandals have had more weight on investor sentiment. This has resulted in investors locking in their profit on the real (see graph above on the right). When the meat-packing scandal was linked directly to President Temer, investors run for the proverbial emergency exit and the real dropped by close to 9% in one day  (18 May 17) versus the US dollar (USD/BRL rallied to above 3.40). Since then, USD/BRL has stabilised but there is some tendency for the real to move lower.

Political uncertainty continues to weigh on the real in the near term

Going forward, political risks are here to stay and will from time to time result in substantial weakness waves in the real. This is why the progress of reforms is crucial for investors. Market expectations about reforms in Brazil are pretty low so a positive surprise could quickly result in a sizeable recovery of the real.

Another important factor is the state of and/or confidence in the domestic economy. This is partly reflected in the behaviour of the domestic stock exchange, the Bovespa. We have just downgraded our economic growth outlook for Brazil (see our Brazil Watch: Recovery killed before it is born). We continue to see downside risks. This will likely send the real lower. Furthermore, we expect the US dollar to be relatively stable across the board and US Treasury yields to rise in the coming months. This is also unfavourable for the real.

On the other hand, we expect neutral to slightly higher commodity prices from current levels and this should provide some support to the real. It is likely that the central bank will continue to dampen excessive moves in currency markets. The central bank has signalled a lower pace of rate cuts ahead. It probably would like to see progress on the reform side and is the impact on the real. For example a sharp weakening of the real will result in inflationary pressures and this will limit how aggressively the central bank can cut interest rates. If we take all this into account, we think that USD/BRL could move towards 3.5 in the near term before moving lower again later in the year on the back of general US dollar weakness and more upside in commodity prices.