The Brazilian real has been the best-performing major currency against the greenback over the last month, after the currency bottomed out from the pandemic-driven market turmoil in mid-May.
Coupled with a global equity rebound on the back of easing lockdown measures and widespread policy stimulus, emerging market currencies started to pare back record losses as markets engage with a strong post-pandemic risk-on sentiment. The real has recovered around 40% of the lost ground since the beginning of the year, despite the grim domestic economic outlook and the poorly managed pandemic situation. In the medium-term horizon, the BRL could continue to strengthen in line with the ongoing trend in emerging market currencies and as the USD broadly recedes. However, the balance of risks to this outlook is heavily tilted to the downside as per the unprecedented levels of economic and political uncertainty. Even though we believe the BRL has already met the bottom of its long-term price against the dollar, a wide set of negative risks are poised to challenge that view in the short run.
Large-scale losses since the start of the year –nearly 46% against the USD and 41% against the EUR- provide the BRL with ample room to rebound as the global economy enters the recovery stage from the pandemic crisis.
The USDBRL pair currently sits 32% over its 5-year average value while it recently peaked at an all-time record high in mid-May. The underperformance of the currency relative to all major peers was particularly triggered by a widespread virus contagion, placing Brazil as the second-largest global epicenter of the pandemic after the US. The country is faced with a severe economic contraction in 2020, forecast on the 6%-7% range according to the median consensus, fundamentally weakening the currency outlook. On top of that, mounting pressure on Bolsonaro’s mismanagement of the pandemic has amplified former political instability in the country, rendering the currency extremely volatile to political developments.
BRL outstrips year-to-date losses against the dollar in the emerging markets space
However, despite the economic and political gloom in Brazil, there are a few arguments to support the view of a gradually recovering real as the year advances…
On the monetary policy side, the BCB is unlikely to exhaust its full firepower from structurally high interest rates, while potentially conducting further accommodation on a gradual manner. Even though the headline and core inflation backdrop remains benign for further interest rate cuts as per the oversized effects of the widening output gap, markets are only pricing in additional rate cuts of 75 basis points in the following months. We do not expect rates below the 2% level since the benchmark rate already rests at its record lowest of 3%; whereas a strong policy normalization is priced in by markets for as soon as one year time. Amid ample monetary accommodation in advanced economies and eased market volatility, the BRL could gain relevant traction on carry trades among currencies in the EM space. Over the last month only, long BRL positions returned over 19% and 13% against the USD and EUR respectively. Even as the easy part of the rally is probably left behind, the real could continue to look attractive in this vein.
Additional monetary expansion in the form of quantitative easing should also be limited in the Brazilian economy, even though the BCB was recently given QE firepower beyond strict monetary policy purposes by the legislative. The reasons for a parsimonious use of this tool is largely based on fiscal constraints, as both a hint of monetary financing and/or yield curve manipulation will only increase the ongoing fiscal deterioration. Instead, the BCB stands prone to targeted action towards improving liquidity conditions mainly aimed at guaranteeing a smooth functioning of financial markets.
Contrasted with swift quantitative easing in other major economies, the BCB’s conservative stance will act as a currency buffer as the worst effects of the crisis ease down. Risks to this view remain in the form of an overly restrictive monetary policy, curtailing Brazil´s economic rebound and reducing external currency demand.
The fine-tuned FX management by the BCB should act as a constraint to sharp currency depreciation, especially during periods of heightened volatility.
Brazil’s foreign reserves fell by $24 billion in March and April to the lowest level since 2011, as the central bank intervened to counter record portfolio outflows. Even though the BCB does not target certain currency levels, President Campos Netos hinted that the BRL decoupling from other emerging currencies on the back of surprising capital outflows was the main trigger for increased FX intervention activity. While the BCB has shown only marginal concern for a weaker real, the institution has recently signaled continued intervention in the currency market in order to prevent volatility outbursts. In this context, just as the BCB is unlikely to deliberately strengthening the currency, it is even less likely to allow for further currency losses. Even though the foreign reserves have fallen sharply over the last couple of months, Brazil´s large reserves as percentage of GDP, serve as a strong floor to any extended BRL depreciation.
Elevated foreign reserves holdings and a strengthened current account should support the real recovery
A strengthened current account on the back of trade flows overturned by the pandemic also remains supportive of a stronger real, both on a trade basis and via enhanced foreign reserves. As domestic demand recedes and the currency weakens, the country´s long-running current account deficit is narrowing rapidly -in April alone it reached a record surplus of $3.8 billion. That might not seem like much of a bright spot as much of the improvement in the current account comes from sharp drops in imports and not from positive changes to Brazil´s competitive structure. However, the buoyed demand for Brazilian soft commodities as the global economy picks up also serves as a booster to the current account: Brazilian exports of scrap steel has increased 64% YTD compared to the same period last year, while soybean exports to China rose 60% YoY in May.
Overall, we believe the real bears a sizeable potential for a rally against the USD and EUR in the path towards year-end, especially since the Federal Reserve has recently strengthened its forward guidance for a dovish stance in the medium run and the ECB is mulling expectations for extended monetary stimulus.
We don’t see, however, economic fundamentals to justify a currency appreciation far beyond the pre-coronavirus levels in the medium-term. On the other hand, although the high mid-May volatility points to a large moderation, we still see looming global and domestic uncertainties threatening the currency outlook to a high extent. Upon stronger and more persistent volatility, Covid-19 and fiscal uncertainties could still leave the BRL under pressure this year. Increased criticism faced by the government on the back of a misguided policy response to the pandemic also revives old threats to the currency from the political front.
Author: Olivia Alvarez Mendez