Brazil Impeachment Rally Loses Steam as Economic Reality Sets In

How to Play the Brazilian Market Now
  • Risk reversal on currency shows traders betting on declines
  • Gap between Ibovespa and forecasts is narrowest on record

The rally that made Brazilian assets the world’s best performers in 2016 is losing momentum as investors’ euphoria over prospects for change in government gives way to pessimism about how hard it will be to pull the country out of an economic malaise no matter who is in power.

The Ibovespa equity gauge, Brazil’s currency and its bonds have soared in the past two weeks as traders bet that the country’s biggest ever corruption scandal is getting closer to President Dilma Rousseff and her party, creating an opening for new leadership that would focus on pulling the country out of its worst recession in a century. As analysts cut forecasts for the economy week after week, a ballooning budget deficit has prompted warnings from ratings companies that Brazil’s debt load could become unsustainable.

The market advance last week was smaller than the week before, and the real and stocks slipped Monday even after millions of anti-government protesters staged some of the largest demonstrations in the country’s modern history over the weekend. Goldman Sachs Group Inc. and Banco Mizuho do Brasil SA say that for a fresh rally to take hold, there needs to be a solid indication that Brazil is on the path to recovery.

“Brazilian assets show that a change of government has been widely priced in,” said Alberto Ramos, the chief Latin America economist at Goldman Sachs in New York. “Now the challenge becomes to look ahead and see if a potential new government will be inclined to reforms. And there are still many doubts remaining.”

The real lost 1.7 percent to 3.6456 per dollar at 3:33 p.m. in New York on Monday. The Ibovespa slid 1.1 percent.

The two-week, 19 percent advance has pushed the Ibovespa’s 14-day relative strength index to 77, near the highest since February 2012, according to data compiled by Bloomberg. Some technical analysts see an RSI of 70 as a signal that a security has risen a lot and could be poised for a decline. The real is also trading above that level.

The real’s 25-delta risk-reversal, a measure of the premium for the right to sell reais over the right to buy the currency, is signaling traders are betting that the real will post the biggest decline among major currencies after the South African rand over the next three months. While the outlook is bearish, it’s less so than in recent weeks. The risk-reversal measure was at 2.1 percentage points on Monday, compared with 2.8 at the end of last month and 5.03 on Oct. 19, according to data compiled by Bloomberg.

And while analysts have turned more bullish on the Brazilian currency over the past two weeks, they still see further decline in 2016. The real will drop 13 percent to 4.2 per dollar in the fourth quarter, according to the average of 51 analyst estimates compiled by Bloomberg.

In another signal the market may have gone too far, too fast, the gap between the Ibovespa and analysts’ 12-month forecast is near the narrowest on record.

While markets have been split in the past about whether a Rousseff ouster would be good or bad, many traders now say it may be the only way out of the political quagmire that has prevented lawmakers from focusing on kick-starting the stalled economy and closing a crippling budget gap. After being stalled in Congress for months, the impeachment proceedings are expected to resume in coming days when the Supreme Court decides on guidelines for the lower house to follow.

“There should be more room for gains once a decision on that comes, even though a lot has been priced in,” said Luciano Rostagno, the chief strategist at Banco Mizuho do Brasil in Sao Paulo, who’s the second-best forecaster for the real in the fourth quarter, according to data compiled by Bloomberg.

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