Real Routed Again As Brazilian Election Odds Reprice

Since crashing through BofA’s “crisis indicator” 4.00 level, the Brazilian Real has gone into freefall, topping 4.09/USD today as markets continue to reprice to new leftist-victory election odds, and the central bank remains cornered on the sidelines.

As Bloomberg details, all this pessimism reflects what’s really an intense distaste for the Workers’ Party, known locally as the PT, among investors and business executives.

They see the government of former President Dilma Rousseff as largely responsible for bringing about the worst recession in a century before she was impeached, and her predecessor Luiz Inacio Lula da Silva as a crook. While the PT has put Lula forth as its candidate, it’s unlikely he will be allowed to run in October because of a corruption conviction. His probable replacement, former Sao Paulo Mayor Fernando Haddad, gets no more love from traders.

“Turkey and Argentina are examples of how disrupting it is for financial markets when investors lose confidence in policy direction and institutions,” said Tania Escobedo, a Latin America strategist at RBC Capital Markets in New York. “Lula’s PT party would represent this scenario, unless it moderates its views significantly.”

One specific concern is that a PT government might seek to unwind the efforts President Michel Temer made to shore up the budget after the country’s credit rating was cut to junk, including a push to overhaul the social security system.

Additionally, as Bloomberg notes, the slump in the Brazilian real has left the central bank between a rock and a hard place – let the spike in volatility run its course, or sell FX swaps and risk failing to curb a move tied to a repricing of election odds.

BCB has already sold near $43.5b of FX swaps this year, squeezing 1-month historical volatility down to 13.2% from 20.8% in mid-June amid FX crisis in Argentina and Turkey. Central bank governor Ilan Goldfajn reiterated several times that BCB may resume use of currency swaps if it considers the FX market to be dysfunctional.

Implied volatility is now back well above level seen in June and the currency is heading towards a record low, but market situation is still far from being considered “dysfunctional.” BCB needs to decide if it intervenes again on volatility spike and FX level, or if it leaves market repricing to end before making a move.

As we noted previously, we suspect they will be forced to do something…because judging by what the analysts are saying – things could get far worse…

  • Brown Brothers Harriman & Co. says the real could tumble more than 20 percent to 5 per dollar.

  • Bank of America Merrill Lynch sees an even bigger drop to 5.5 under its worst-case scenario for the next government.

  • The Ibovespa stock index may lose more than a third of its value, according to the local hedge fund Rio Bravo Investimentos.

An unfavorable outcome in the presidential election as well as negative sentiment toward emerging markets globally could send the real to 5 per dollar, according to Win Thin, a strategist at Brown Brothers Harriman in New York.

“Whoever Lula backs would be the worst scenario,” Thin said. “We can assume that a lot of Lula’s support will flow to whomever he chooses to be his proxy.”

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Author: Tyler Durden