The Brazilian real has been the worst performing currency this year, with losses currently sitting over 22% and 26% against the USD and the EUR respectively. In addition to this, the BRL is the most volatile currency in the world when considering calculation periods from 1-month up to 1-year.
The pandemic has taken its toll on the Brazilian economy, exacerbating an already fragile domestic panorama and forcing the halt of necessary fiscal reforms in the country. After suffering the most deaths from Covid infections in June and July, Brazil has moderately managed to control the health situation, slowly restoring confidence over the economic outlook. Wide support from fiscal and monetary policies also underpins the speed of the expected economic recovery, while also leaving a loose support under the currency. With ample room for correction, the BRL is set to pair back losses as the economy gradually recovers and the USD retreats on a broad basis.
However, a comprehensive set of downside risks could mean the currency struggles on its way back, especially against the rallying EUR.
Moreover, with most investor’s attention tilting to Brazilian fiscal dynamics and the uncertain evolution of the pandemic, the highly volatile narrative is unlikely to abandon BRL price action in the following months.
The progression of the pandemic over the last month has helped boost the economy, although severe health issues still linger in the Brazilian panorama. The seven-day moving average of Covid-19 deaths continues to downtrend, and currently sits close to 700 from 1000 in July and early August. The reduction of daily casualties led to a relaxation of stringent policy response measures, even though studies show that several cities in Brazil do not meet the WHO criteria for policy easing. GDP is expected to contract 5.45% this year, with a full recovery projected by mid-2022. According to the central bank’s monthly indicator of real GDP (IBC-Br), real activity declined 14.7% cumulatively during Mar-Apr, and expanded 9.6% during May-Jul. Data for services has been notably weaker than for both the production and consumption of goods, reflecting the nature of the Covid-shock. However, while the viral pandemic is yet to be brought under control, recent data suggest that activity hit rock bottom and reached an inflection point sometime in mid-April.
Brazil remains among the top Covid epicentres despite positive progress over the last month
Policy support has been a key factor in the recovery of real activity, with an ample degree of fiscal and monetary expansion put forward.
Fiscal measures announced add up to 11.5% of GDP, which is estimated to provide a direct impact of 7.5% to GDP in 2020. The government also lifted the constitutional spending ceiling for a separate “war” 2020 budget covering exceptional spending needs. The fiscal measures include temporary income support to vulnerable households, employment support, lower taxation and import subsidies on essential medical supplies, along with new transfers to local governments as a cushion to the expected fall in revenues. Concerns over the medium-term fiscal outlook remains though. If the new social welfare programmes are forced to be extended over a challenging pandemic situation as feared by investors, the spending ceiling could be compromised in 2021 and beyond.
On the monetary front, the Bank of Brazil has also made unprecedented moves regarding policy stimulus. The bank cut interest rates to the record low 2% level – 250 basis points down from pre-pandemic levels – taking the benchmark to its estimated lower effective bound. Moreover, the BCB committed to more explicit forward guidance on policy rates, a tool often used by central banks from developed economies and rarely in emerging markets. Through this instrument, the bank promises to avoid policy normalization until certain goals in the economic outlook are met, setting the tone for a lower-for-longer interest rate environment akin to that implemented by the Federal Reserve.
Even though forward guidance does not rule out taking rates even lower, further interest rate cuts remain unlikely due to the potential credit risks to the financial system.
The Copom itself acknowledges that the “unprecedentedly low interest rate environment may generate increased asset price volatility”, for which “possible new interest rate reductions would demand caution and additional gradualism”. With the most cost-effective tools already deployed, there is limited scope for further monetary accommodation – QE remains an option unlikely to be considered as well. Beyond this point, however, the policy rate path could be significantly influenced by the fiscal profile, as the implemented forward guidance is explicitly conditioned on the preservation of the fiscal regime, along with the desired anchoring of inflation expectations.
The combination of low interest rates over the medium-term horizon and concerns over increasing fiscal expansion has resulted in a steepening in the yield curve at the back-end of the curve due to rising inflation expectations.
From a generally comfortable inflation backdrop before the pandemic, concerns over a loose fiscal outlook amid relaxed financial conditions are starting to filter into increasing inflation prospects. One-year inflation breakevens, the spread between nominal bond yields and those from inflation-linked bonds, quadrupled to nearly 4% from less than 1% in May. Meanwhile, implied inflation in the two-year linkers jumped to over 4% from less than 3% in March. While consumer prices are rising at the weakest pace in more than 20 years, investors are betting that the jump in wholesale prices might spill over into headline inflation in the coming periods, while fiscal support measures are also expected to underline the inflation outlook. The upside bias to the inflation outlook in the BCB´s assessment of risks is likely to drive the bank’s reluctance to cut interest rates any further.
Concerns over the fiscal outlook amid loose rates bring back the anticipation of high inflation
While the fiscal and monetary backdrops set a loose floor for the Brazilian real, speculation over the BCB’s appetite for FX interventions has been largely put to rest. The BCB has repeatedly said it would only intervene if the market were dysfunctional, a notion that has firmed through steady FX swaps operations in the aftermath of the pandemic. Compared to historical standards, the limited intervention in currency markets amid the record high BRL depreciation denotes little concern for the exchange rate as the economic crisis evolves. The BCB is likely to stay put from intervening in currency markets despite President Bolsonaro’s comments about the weak real.
However, we continue to believe that the BCB would still act should the BRL tests recent record lows, limiting the scope for further depreciation. However, with evidence of a less committed approach towards a stronger currency, potential BCB interventions in FX markets has turned into a weak support for the real.
Additionally, the absence of a strong carry appeal as the BCB’s policy-easing cycle ends suggests that the BRL will struggle to navigate back to its pre-pandemic levels, even as investors start to focus on finding value amid fewer risk-reward appealing options in international markets. For this reason, we don’t expect the USDBRL rate to return to pre-virus levels until the first half of 2021, where we expect a stabilisation in global conditions, a more mature global recovery and a return of investors to the higher risk EM space.
BCB is barely worried about the weak currency as per the underperforming FX intervention
Author: Olivia Alvarez Mendez, FX Market Analyst