Brazilian Real: Update to the Downside

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

Comments

[Chris B:]

So I guess this means to avoid Brazilian equities too...

2008 Aug 25 01:17 PM

[Ray Hendon:]

I still like their equity ETF (EWZ). There is often a disconnect between a currency and equities, and I feel much stronger about the economy of Brazil than I do their currency, at least over the next months. The currency was simply oversubscribed by the carry trade hot money. EWZ has taken its hits lately, as all emerging markets have, but I think this will pass once commodity prices stabilize and they do some test drilling in their new oil fields off shore. But, it's still risky for either investment.

2008 Aug 25 01:45 PM

[Think-About-It:]

I've had my finger on EWZ for a while and really want to buy it (I like PBR, RIO and their Banks) but if the Real drops 10% or so then that's tough to make up.

2008 Aug 25 09:24 PM

[Ray Hendon:]

With respect to the prospects for EWZ I would encourage you to split your views into the short run and the long run. If your horizon is short, say, a year or less, then EWZ is not a strong prospect for gain. A 10% gain for Brazil is not out of the question; their recent gains have far exceeded that amount. But you do need to extend your horizon some to be more certain of coming out ahead.

Equity markets are in a transition stage, especially in the developing world, where there have been huge gains over the last few years. They will pay back some of their gains as the effects of world inflation and slowing Europe and America take their toll. But Brazil is in such a good position to profit from the commodities boom, that they must eventually prosper more than most others. They have so far to go, and for the first time in their history, they have the infrastructure in place to make something out of it.

But they are strictly a longer term play.
.

2008 Aug 26 12:34 AM

[eliana:]

The mystery to me is how much of the decline in the Real is attributable to US and other investors liquidating to meet cash needs. I have watched the Brazilian central bank fight hard against the rise of the Real and fail. Logic suggests they bank is equally unable now and the move is the result of market forces, but what forces, exactly? Declines in demand for raw materials? What is the role of panic in favor of investing in Treasuries as a defense?

2008 Oct 03 10:01 AM

[Mad Hedge F...:]

yhb Hoping to beat the rush, I ordered my Rosetta Stone Portuguese language program last week, fully expecting Rio de Janeiro to win the 2016 Olympics bid. Pick pockets of the favellas of Latin America’s largest city were ebullient. A cheer even went up on the floor of Chicago’s CME, now that the denizens of the Windy City are dodging a monster tax bill. Of course, Obama was in a no win situation, with mud on his face for his failed pitch, and blamed for defeat if he didn’t go. There was never any doubt that the home of the string bikini and the banana thong was going to win. In order to justify the gargantuan cost of the modern games, the International Olympic Committee long ago turned this into an emerging market development program. The great news for investors is that corresponding emerging stock markets have a history of tenfold returns going into the games. Look at South Korea and China. Only the 2004 Athens games were a bust, the home of the Olympics building a games that were far more than it could afford. I have long been a fan of the country that is doing everything right, with a perfect demographic pyramid and a liberal pro business government fueled by resource and energy exports. I managed to catch a 270% leap for my subscribers in the ETF (EWZ) this year. I wouldn’t’ rush out tomorrow and buy on the news, as an impending global stock market selloff is likely to pull it down with everything else. But it definitely should be at the top of your “buy on dips” list.

Oct 04 05:40 AM