The central bank of Brazil’s policy to lower FX volatility has created profitable investment opportunities for international investors while exacerbating domestic economic weaknesses.
Investors and economists say Brazil is opening profitable trades for offshore asset managers by its targeting of a valuation band to the dollar. The suppression of volatility by the BCB’s clear maintenance of a band of between R$2.20 and R$2.30 has led to large inward flows to local currency bonds that offer very high relative interest rates.
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| We continue to be long Brazilian rates, because we think it continues to be a great trade with or without the elections Edwin Gutierrez |
The BCB’s intervention in the FX market began in May 2013, when emerging market currencies faced pressure during the so-called taper tantrum. However, the BCB’s use of dollar swaps to maintain the band has been clearly and consistently signalled to the market, with the management of FX valuation now the key instrument in the country’s dual strategy to fight inflation while maintaining some level of GDP growth. This FX valuation certainty has led to a rally in local currency bonds as investors crowd in to take advantage of the local rates with minimal FX risk.
Goldman Sachs says the market has internalized this band and investors are now reinforcing it by replicating trading decisions aligned to these artificial parameters – buying near the floor.
“It is very difficult to take on central banks that have a lot of reserves,” says Edwin Gutierrez, senior investment manager at Aberdeen Asset Management in London. “We tend to play the range. We know this is a very high carry currency – it is very painful to short the currency – and so any time it weakens we look to add some real exposure. Our primary exposure to Brazil is Brazilian bonds – that’s what we like and that’s been a great trade for us. We have been less enthralled with the currency, but that’s done well anyway with the carry – it just shows how painful it is to bet against the real because of the high carry.”
Rally
Local bonds have been rallying, with yields on some 10-year trades falling by 200 basis points in recent months. However, this reflects not just the profitable carry trade but is also part of a general repricing of Brazilian assets as the country’s general elections in October become closer to call.
“The base case is that it is still Dilma [Rousseff]’s election to lose, so there is a lot of upside in the event of an opposition win,” says Gutierrez. “That’s why you have seen such a strong rally – the chances of a Rousseff loss are increasing and so Brazilian financial assets are doing well. We share that view and that’s the reason why we continue to be long Brazilian rates, because as well as being higher than any other EM country – with the exception of some frontier markets – we think it continues to be a great trade with or without the elections. If the opposition wins, you haven’t seen anything yet in terms of the rally – it is going to be phenomenal, even from this point [in the rally].”
However, despite some attractive capital flows to the local bond market the BCB’s maintenance of the FX valuation band is controversial.
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The FX intervention stance and balance of risks may change in 2015 as the current strategy is relatively costly
Goldman Sachs
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The outstanding level of dollar swaps is relatively high – and potentially expensive. Goldman Sachs predicts that the stock of dollar swaps will reach $93 billion by the end of July and $95.1 billion at the end of August. The bank says that the market has adopted the R$2.20 to R$2.30 range and it is keeping the real over-valued, which the bank believes should be trading at a theoretical fair value of R$3 to the dollar.
“Despite the 30% nominal BRL deprecation against the USD since mid-2011 and a very weak growth backdrop, rather than any meaningful adjustment of the external accounts, we have actually witnessed further steady trade and current account deterioration over the last two years,” Goldman notes. “Rather than tightening fiscal and quasi-fiscal policy and hiking the Selic policy rate to the full extent needed to anchor current and expected inflation, the Brazilian authorities are likely to use the exchange rate and administered prices/tariffs to control inflation, at least until the October elections. However, the FX intervention stance and balance of risks may change in 2015 as the current strategy is relatively costly from a macro standpoint and the outstanding stock of dollar swaps is relatively high. Therefore we are medium term BRL bearish… we expect the BRL/USD to trade close to 2.30 in three months, but to depreciate to 2.40 and 2.55 in six and 12 months respectively.”
While some investors think the yield from the local currency play is too high to ignore, HSBC also cautions that at some point a return of volatility will weaken today’s carry trade.
“Nominal yields around 13% and real yields above 6% certainly have not gone unnoticed. Despite significant headwinds for local markets and very high volatility in Brazil itself, the local bond market has seen significant inflows from foreigners since June when the IOF tax was removed,” HSBC wrote in a Latin America fixed income report published in July.
“Even though our analysis shows that the long end is too steep, we expect the curve to retain a high level of risk premium. Nonetheless, factoring in our forecast for a weaker BRL, expected returns melt to the low single digits, not very appealing given the likely persistence of high volatility, which will only be exacerbated by fiscal and downgrade concerns.”
