Emerging Market Currencies: What’s Driving the Brazilian Real’s Strong Outperformance?

Four months into 2014, the Brazilian real is the strongest-performing currency across the broader emerging markets (EM).¹ With most other major currencies mixed against the U.S. dollar year-to-date, what is driving the nearly 7% return for the real? In our view, a variety of forward-looking factors may have investors bullish on the real, including: • Attractive absolute and real interest rates • Brazilian Central Bank² (BCB) rate hikes to combat inflation • Declining presidential poll numbers that suggest a potential greater willingness to compromise • Increasing credibility about rumors of a Cabinet shuffle to help the economy With the World Cup just around the corner and presidential elections occurring in October, we believe globally minded investors will continue to take interest in the Brazilian economy and real. Attractive Interest Rates Brazilian local debt and currency forward contracts offer the highest interest rates among investment grade bonds across emerging markets: five-year local debt yields 12.2%, whereas three-month forwards provide implied yield of 10.83%.³ Additionally, despite the inflation rate remaining above the BCB’s target, Brazilian debt offers real yields of 4.7% to 5.0%, which are also the highest among investment-grade rated sovereigns. In the current environment, these yields provide a significant cushion against a possible deterioration in the real, which has historically exhibited a fair degree of volatility. For investors still searching for yield, small allocations to the Brazilian real can provide significant yield enhancement. Central Bank Rate Hikes and Policy Tools Even though markets tended to focus on the Federal Reserve's announcement about the scaling back of its quantitative easing program, the BCB was actually one of the most active central banks in terms of hiking interest rates to both defend Brazil’s currency and confront rising inflation pressures. During the last couple of years, the central bank has sought to strike a balance between trying to support Brazil’s slowing economy and keeping inflation under control. Even though Brazil saw a dip in inflation in January, it has generally run above the central bank’s targets over much of the last year.⁴ In response, the BCB is expected to hike rates by 25 basis points on May 28.⁵ As an additional policy tool, should the currency retrace from current levels and stoke inflationary fears, the central bank could help dampen price pressures by reinstituting a fresh round of currency swaps similar to ones that the central bank let expire at the end of April. In these transactions, the central bank effectively would sell U.S. dollars for Brazilian reais, giving support to the local currency. By allowing the currency to appreciate, imports become comparatively less expensive, resulting in lower prices. Additionally, exports become less attractive to foreign buyers, potentially curbing demand. Ultimately, should the BCB reinstitute its currency swap program, we believe a new wave of real buyers would come into the market, pushing the currency higher. Declining Support and Rumors of a Cabinet Shuffle Unfortunately for policy makers, Brazil’s currency strength is not occurring in a vacuum. With inflation at elevated levels and economic growth stagnating at less than 2%, many Brazilians have voiced their dissatisfaction with Brazilian president Dilma Rousseff and her leadership. In our view, aggressive central bank policy has not been complemented by needed reforms on the fiscal side. Over the last several months, President Rousseff’s approval rating has continued to fall in public opinion as well as presidential polls. On April 29, the Brazilian real appreciated by more than 1% on the news that Rousseff’s popularity had fallen compared to her competition. In the local poll conducted by MDA, if the election were held then, 37% of Brazilians surveyed said they would vote for her, compared to 43.7% in February. By comparison, her strongest competitor, Aecio Neves, perceived as the most pro-business candidate, gained ground to 21.6% from 17%. In a similar poll, her administration’s approval rating fell to 32.9% in April from 36.4% only two months earlier. While the campaign season hasn’t even jumped into high gear, the trends in these polls are clearly inspiring investors to increase bets on a shift in policy. While technically still leading in the polls, President Rousseff may be on the verge of taking steps to ingratiate herself to business interests to help reverse her fall from grace. Rousseff’s Potential Response Market participants have been bullishly greeting her slide in the polls as they try to place bets in front of any potential efforts to consolidate support and appease market interests. Rumors have been circulating for months about an impending Cabinet shake-up. In the most likely scenario, current central bank governor Alexandre Tombini is expected to take over Guido Mantega’s position of finance minister. Markets appear excited about this prospect. It’s hoped that Tombini’s recent comments about the importance of refocusing the government on its fiscal deficit would signal the administration’s willingness to restrain government largesse. In Tombini’s place, Luiz Awazu Pereira da Silva, a well-respected deputy governor and international affairs director of Brazil’s central bank, is expected to take over the top spot at the BCB. With time running out before the election and tempers potentially rising along with temperatures this summer, markets are trying to get in front of this potentially positive catalyst. While Rousseff hopes that a change in economic leadership will help put the Brazilian economy back on track, many foreign investors are hoping that her competitors will gain additional ground leading up to October. Outlook At present, many currency forecasters are predicting that the real will stay range bound leading up to the World Cup on June 12. However, should the real break through the 2.20 level on the back of strengthening demand, this could signal a shift in investor psychology, resulting in a possible move to the lows we saw last October (2.15, +3.8% appreciation).⁶ While interest rates are only one factor in currency trading, it is worth mentioning that rates will be a full 1.75% higher than when the currency was trading at these levels in mid-October. As we mentioned in a blog post back then, we see many potential catalysts for the real to move higher, should flows into the broader emerging markets pick up steam. While volatility in the real could increase at any time, we think it offers attractive risk-reward and total return potential near current levels. ¹Source: Bloomberg, as of 4/30/14 ²Banco Central do Brasil in Portuguese ³Source: Bloomberg, as of 4/30/14 ⁴Source: Reuters, as of 2/7/14 ⁵Source: J.P. Morgan, as of 4/30/14 ⁶Source: Bloomberg, as of 4/30/14