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When Brazil’s populist former president Luiz Inácio Lula da Silva was jailed for corruption this month, markets were expected to cheer the end of the leftist leader`s comeback hopes in elections this year. But instead of rallying, Brazil’s currency, the real, headed in the opposite direction, breaking out of its previous range of R$3.20 to R$3.30 to the dollar and touching some of its weakest levels since 2016 of above R$3.40. While politics was the catalyst for the sudden slide, the weakening of the real has been coming for some time as part of what UBS is calling the “Great Unwind” — a mixture of the end of a carry trade in the currency combined with the liquidation by the central bank of billions of dollars of swaps that were used by investors for hedging.
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“The theme of a weak real is getting a lot of attention now because we broke out of that range, but the truth of the matter is it’s been kind of weak for quite some time,” said Tony Volpon, economist with UBS. Brazil has been among the best-performing emerging markets over the past year, led by equities but with a relatively stable real providing a backstop. Share this graphic The stock and currency markets languished in 2015 under Mr Lula da Silva’s anointed successor, former president Dilma Rousseff, before surging on her impeachment and replacement with her more business-friendly vice-president Michel Temer in 2016. Mr Temer’s economic team pushed consumer price rises down to two-decade lows with inflation at 2.68 per cent by end-March against a year earlier. This has allowed for record-low interest rates. The Ibovespa, the benchmark equities index, has more than doubled from its lows in January 2016, over the past year alone returning 30.7 per cent. The real, after reaching levels of more than R$4 to the dollar during the Rousseff years, was trading at R$3.20 to R$3.30 for much of the past year before its sudden depreciation in the past two weeks. Mr Volpon argues that the outperformance of the Ibovespa compared with the real suggests that factors other than economic fundamentals are behind the currency’s weakness. Share this graphic The most obvious is the central bank’s longer than expected easing cycle with short and long-term bond yields in Brazil falling steadily compared with the US. Brazil’s central bank has cut the benchmark Selic rate from 14.25 per cent in October 2016 to 6.5 per cent in March. Another cut is expected at the next meeting in mid-May This comes as the US is tightening monetary policy, further reducing the attractiveness of the real as one of the world’s great carry trade currencies. But Mr Volpon argues that the currency’s weakness has been exacerbated by the Great Unwind. During the Rousseff presidency, the central bank sold $114bn in currency swaps to help smooth volatility in the real, driven by domestic political uncertainty and doubts over US monetary policy. Under the swaps, the central bank committed to compensate counterparties for any fall in the real against the dollar in return for receiving interest payments at the Selic rate. The swaps provided a hedge for investors buying Brazilian real-denominated assets to take advantage of the carry trade. However, since 2016, the central bank has been reducing its stock of swaps because of lower market volatility. These totalled almost $24bn by the end of 2017. Without the swaps to act as a hedge, foreign investors have been reducing their exposure to the Brazilian carry trade even more, Mr Volpon said, in the process weakening the real.
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While Brazil’s fundamentals, such as its terms of trade, should justify a stronger currency, for now policymakers would likely welcome the boost to exports from the lacklustre real, Mr Volpon said. “I think a weaker currency is not a bad thing when your growth is still low,” he added. Others argue that the real’s weakness was likely to also be part of a “risk off” trend as investors fret the world is braced for the return of inflation and higher interest rates, which could tip developed markets into recession. “It’s not a Brazilian thing,” said Walter Molano, at BCP Securities, of the weakness affecting the real. In the meantime, the currency is likely to be buffeted by the October election. Polling at the weekend showed that jailing Mr Lula da Silva, who had been leading in the polls, had put extreme-right former army captain, Jair Bolsonaro, in the lead, followed by environmentalist Marina Silva and former chief justice Joaquim Barbosa. All of them face question marks over their ability to manage Latin America’s biggest economy or to continue with reforms started by Mr Temer. The economy is expected to expand 2.5 per cent this year and 2.8 per cent next year, according to estimates from FocusEconomics. “A market-friendly outcome from October’s elections is . . . critical to supporting the economy’s outlook,” FocusEconomics economist Angela Bouzanis wrote in a note.