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Brazil has been a stellar attraction to carry traders for well over a year.  With a current interest rate over 10% and a strong economy, Brazil is characterized by rising income, increasing exports and an expanding middle class.  A recent oil discovery in the South Atlantic, in their territorial waters, promises to make Brazil the next Saudi Arabia, although the reserves are not yet proven.  Things have been going well for a nation that was for centuries bogged in dictatorship and an economy plagued with poverty and frequent bouts of rampant inflation.

Inflation in Brazil today is well within bounds when compared to the rest of the world --all of us have to pay more for almost everything, and Brazil isn't exempt.  In its favor, the administration of President Luiz Inacio Lula da Silva has established credibility as friendly to business and one that welcomes foreign investment.  The central bank has a credible reputation for keeping inflation within its target.  Its interest rates are quite high; Brazil use higher interest rates to fight inflation, just as we do.  But, high interest rates have made it a target for international hot money flows, and policy makers must take steps to demonetize these flows to prevent them from overvaluing their currency.

These efforts have not been 100% successful (they rarely are), so the Brazilian central bank will probably allow the real to come down against the dollar for well into 2009.  This will help dampen domestic demand by making imports more expensive. This is needed, because the domestic economy is quite hot.  Recent job growth and expanding domestic wages, have caused its current account to slip into deficit.  The recent dip in commodity prices has also contributed to the slide; the deficit grew to $17.4 billion in the first half of this year—a level not seen for decades.

No one knows how much it will fall or for how long.  Nevertheless, a falling real will definitely chase dollars out of Brazil.  In a recent article from Bloomberg, Adriana Brasileiro cited a number of economists who are predicting a tough time for the real.  It has fallen over 4% in the last few weeks, and it is widely believed to be in for another 9% or 10% fall by the end of 2009. Hot money is fickle that way. 

It may not be as bad as it appears now, though.  The central bank might allow the real to drop more slowly.  They certainly have the reserves to support their currency at any level they choose.  But they need to control domestic demand, and a depreciating currency is a viable tool for this purpose.  For these reasons, it is difficult to strongly recommend Brazil as a carry trade target any longer.  In spite of my earlier citation of the opinion of Mr. Michael Gomez of PIMCO supporting the real ("Currencies: Dead Cats and Yapping Dogs"), it is probably time for both of us to change our minds.  I certainly have.

One of the many things about currencies that make them so unpredictable is that they are often used as policy tools to accomplish a nation’s objectives.  The problem comes when the policy and objective are kept secret.  The recent rise of the dollar, for example, may be an instance of a secret policy.  The U.S. Treasury Department bought dollars last month--this is documented in their own filings.  The Treasury Secretary has not announced an explicit policy of supporting the dollar with anything other than words, but the Department he heads has entered the market in a way that adds substance to his policy beyond mere words. 

This is a 180° turn from the last seven years of the Bush Administration.  It has allowed the dollar to languish to peso-like levels in order to finance our huge trade and domestic budget deficits.  But now, there is an election coming, and it appears the Administration is looking to strengthen the dollar and lower the price of oil. Imagine that!

Coincidence is, of course, not proof of anything.  And, in a sense, it is probably unwise to always announce your currency policies to the public.  A well kept secret may be in our interest as we attempt to manipulate the market price without others knowing our intentions.  If you give it away up front, you may not get what you want once the dust settles.    

The bottom line to this screed is that we can't know the heart and mind of the Brazilian government any better than we can know our own.  That's what makes currency trading so cockeyed and why fortunes are made and lost so quickly.  Drought, pestilence and famine we can handle.  They are random events that currency markets are used to.  Secret polices are something else.  We simply have to make our best guess and hang on.  For Brazil, I'm putting the real on my endangered list for carry trade balances until the tide turns, whenever that may be.  I’m not selling out yet, but my finger is on the trigger.  I think the dollar is on the upside and the real on the down, especially until the second week in November.  After that, its anybody's guess.

Disclosure: Author owns BZF and UUP

Source: Brazilian Real: Update to the Downside