The Brazilian real came under renewed pressures starting mid-October as US yields initiated a much-awaited recovery. The entire EM complex suffered as the entire US yield curve shifted to the upside. The move is far from over as the 2-year Treasury yield hit a 9-year high yesterday and tested the 1.6535% threshold before stabilizing at around 1.64%. The shrinking interest rate differential between the US and Brazil is reducing the incentives to invest into riskier emerging market assets.
Regarding the Brazilian real, investors are being more cautious against the backdrop of lower Brazilian rates and uncertainties about the pension reform. The government led by Michel Temer was poised to water down the original version, as it didn’t have enough vote to pass Congress. Obviously, investors reacted negatively to the news as it means that more time will be necessary to reduce the fiscal deficit.
Finally, the central bank is expected to slow down the pace of easing as inflation has moved below the central bank’s target band of 4.5%+/-1.5%. Inflation has stabilized at around 2.50%y/y since the end of the summer. Now that the BCB has successfully brought back inflation down to acceptable levels, the market do not expect more than another 50bps this year, which bring the Selic rate to 7%.
Although the real has room to improve against the backdrop of improving economic condition, we believe the tighter US monetary policy will reduce significantly investors’ appetite for Brazilian assets, especially since the government appears to struggle passing its reforms. The 3.0 level in USD/BRL is a solid support and there is little chance of USD/BRL moving below.
By Arnaud Masset