Interest in the real due to higher rates may be short-lived

Brazil’s staggering monetary tightening cycle may finally be tempting Foreign investors to dip its feet into South America’s largest economy, although accelerating inflation and political risks mean this rebound could be short-lived.

The real has strengthened more than 4% so far this month, even against the strength of the dollar, and has had the strongest performance among the major currencies and has partially reversed its previous decline. The currency has rebounded and swap rates have fallen despite the government moving forward with a spending bill that worries investors, because there is concern that its rejection could lead to an even more uncertain fiscal plan.

It may be a sign that around 575 basis points of increases in the interest rates from the central bank since March are finally having an impact, but perhaps it is too early to declare that the country has truly returned to being a destination for carry trade operators, especially considering that next year the country will have presidential elections. Implied volatility has traditionally been the enemy of investors who seek to borrow in countries with lower rates and put money to work where returns are still very high.

“It’s definitely carry trade already as the central bank continues to raise rates,” said Brad Bechtel, Jefferies’ global head of foreign exchange. “But it is too volatile to own them only as a carry. The volatility needs to cool down for that to develop further and with the elections a year away, it will take time. “

The one-month real implied volatility has ranged between 16% and 18.5% since July. However, while that marks something of a stabilization, it remains the highest among the top 15 emerging markets analyzed by Bloomberg. For the carry trade to really come into play again, volatility should be closer to 10% or 12%, according to Bechtel.

However, today, traders avoid selling short-term volatility in the real. That’s partly because the gamma indicator it generates is paying off despite the high cost of carry, and the currency frequently oscillates between being the best performing to the worst performing in a single trading day. .

And the factors driving those kinds of changes don’t seem to dissipate anytime soon. A stronger-than-expected year-on-year inflation reading this week of 10.7% shows that the central bank is struggling to gain traction with its policy, especially as the government adds fiscal fuel to the fire in the run-up to next year’s elections. The swap curve, which is currently inverted, shows that investors are increasingly skeptical of growth.

And with the election itself shaping up to be a contest between free-spending incumbent Jair Bolsonaro and former President Luiz Inacio Lula da Silva, whose post-incarceration intentions remain somewhat unknown, political risk will continue to shadow the market.