A Quiet Rally In The Brazilian Real

About: iShares MSCI Brazil Capped ETF (EWZ), Includes: BRF, BRZU, BZF, BZQ, EWZS, FBZ, UBR
by: Andrew Hecht

The Brazilian currency has been rallying since May 20.

The new administration pledged reforms.

Brazilian stocks have outperformed.

Brazilian commodities rallying.

Technical levels to watch in the real - EWZ should move with the currency.

Brazil is the country with South America's leading economy. It has enormous potential given its attraction for tourism because of its diverse geography. However, it is a combination minerals, ores, energy, and metals in the crust of the earth, climate, fertile soil, and the availability of water that makes Brazil a raw material supermarket to the world.

Decades of corruption and political instability caused the economy to falter. One of the best barometers of a country's economy is the value of its currency versus other foreign exchange instruments around the world. The US dollar is the leading reserve currency because of the historical strength of the US economy and political stability. Therefore, the dollar serves as a benchmark for other currencies around the world. In 2011, when commodities prices were booming, the Brazilian real traded to a high at $0.65095 against the US dollar. Slumping raw material prices, political scandals, and corruption in the public and private sectors sent the Brazilian real to a low at $0.23455 in late 2015. After a recovery to $0.32815 in 2017, the real began to fall in 2018. At $0.25660 on June 6, Brazil's foreign exchange instrument remained near the low at almost one-third its value back in 2011. Brazil is a leading producer and exporter of a host of commodities. The low level of the country's currency has weighed on prices as it reduces the cost of production.

There are signs that the real could be making a comeback, which would be bullish for both the local stock market and for many commodities prices that would need to rise in US dollar terms as the cost of production increases. The iShares MSCI Brazil Capped ETF (EWZ) and the prices of three of the soft commodities are watching the level of Brazil's currency for clues that it could be ready to head for higher levels against the US dollar.

The Brazilian currency has been rallying since May 20

After reaching a low at $0.24225 during the week of May 20, the value of the Brazilian real versus the US dollar turned higher.

Source: CQG

As the weekly chart highlights, the Brazilian currency has rallied over the past three weeks, reaching its most recent high at $0.25820 this week. The new administration in Sao Paulo made promises on the campaign trail, and if they follow through, there could be lots of upside in store for the nation's currency.

The new administration pledged reforms

President Jair Bolsonaro ran on a platform that he would clean up corruption in both the public and private sectors that have weighed on the country's economy for many years. The far-right candidate won the election and took over in late 2018. President Bolsonaro's business-friendly pledges were also highly critical of China during the campaign as he asked Brazilians if they wanted to have their future in the hands of the government in Beijing. For many years, China has made significant investments in commodity-rich Brazil to guaranty the flow of raw materials, as the Chinese have done in many countries around the globe. President Bolsonaro also embraced US President Donald Trump and his approach to economic growth through fewer regulations and lower taxes that he believes creates an environment where business can thrive. If the new leadership in Brazil is successful in cleaning up at least some of the corruption, and they introduce policies that boost economic growth, the prospects for a significant recovery in the real will rise. The recent move could be just the tip of the iceberg if the President can deliver on his campaign promises.

Brazilian stocks have outperformed

The price action in the US stocks market since September 2018 has been rocky.

Source: Barchart

The chart of the S&P 500 SPDR (SPY) shows that the ETF that measures the performance of the S&P 500 reached a peak at $293.94 per share on September 20, 2018. After lots of price action on the up and the downside over the past eight months, the SPY was at around the $283.05 level on June 6, a decline of 3.7%.

Source: Barchart

Over the same period, the iShares MSCI Brazil Capped ETF product moved from a low at $30.65 on September 13, 2018, to $41.88 on June 6, a rise of 36.6%. The EWZ holds shares in Brazils top companies including:

Source: Yahoo Finance

Brazilian stocks have outperformed US stocks since the election of President Bolsonaro, and that could translate to gains in the Brazilian real versus the US dollar over the coming months.

Brazilian commodities rallying

In the agricultural sector of the commodities market, Brazil's climate and geography support production of a myriad of products. Brazil is the world's leading producer and exporter of Arabica coffee beans, sugarcane, and oranges. The three commodities have futures that trade on the Intercontinental Exchange. Those futures contracts use the US dollar as the benchmark pricing mechanism because the greenback is the reserve currency of the world, and the exchange is in the United States. Meanwhile, production costs for all three commodities are a function of local factors. A weak Brazilian currency causes output expenses to drop as the production of the agricultural products are labor intensive. The recent move to the upside in the Brazilian currency from the low on May 20 sparked recoveries in the coffee, sugar, and FCOJ futures markets. The real moved from $0.24245 on May 20 to its most recent high at $0.26010 on June 5, a rise of 7.3% over the past few weeks.

Source: CQG

The daily chart of ICE sugar futures shows the sweet commodity moved from 11.36 cents on the July futures contract on May 21 to its most recent high at 12.53 cents per pound on June 5, a rise of 10.3%.

Source: CQG

The price of frozen concentrated orange juice futures on ICE moved from $0.9510 on May 21 to a high at $1.1260 on June 4, an increase of 18.4%.

Source: CQG

On May 21, Arabica coffee futures on ICE traded to a low at 88.50 cents, and on June 4 the high was $1.0615 per pound. Coffee futures rose by 20% at the high.

Brazil is the world's leading producer and exporter of all three soft commodities. The rise in the real was a significant factor that lit a bullish fuse in the three futures markets. In many ways, the soft commodities trade like proxies of the Brazilian real-US dollar currency relationship.

Technical levels to watch in the real - EWZ should move with the currency

The first level of significant technical resistance for the Brazilian real stands at the 2019 peak at $0.27475. Above there, the late 2018 peak at $0.28035 is the next level on the upside. Support is at the May 20 low at $0.24225, and at the 2018 bottom at $0.23625. Time will tell if the recent bounce from near the lows will continue, but the Brazilian currency has lots of room on the upside for gains before it hits the first level of resistance which could be very bullish for the prices of the three soft commodities over the coming weeks and months.

When it comes to the shares of Brazilian companies, their future path of least resistance is a function of changes in the real-dollar currency relationship.

Source: CQG

The chart of EWZ shows that as the Brazilian real rallied by 7.3% against the dollar since May 20, the ETF has taken off on the upside. EWZ moved from a low at $36.70 on May 17 to its most recent high at $42.60 per share on June 5, a rise of 16.1% over the period.

The rally in the value of the Brazilian real has not captured many headlines since May 20, but the higher South American currency has taken three soft commodities and the Brazilian stock market higher at a time when the world is focusing on protectionism and a trade war between the US and China. If President Bolsonaro begins to deliver on his campaign promises, Brazil could emerge as one of the biggest and most bullish stories of 2019.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.

The author is trading Brazilian-related products from the long side of the market