Real’s Turnaround Seen Fleeting as Brazil Bewilders: Currencies

For the world’s biggest foreign-exchange trader, the Brazilian real’s 11 percent rally from a 4 1/2-year low is just another reason to sell one of the “bad apples” of emerging-market currencies.

Deutsche Bank AG says a possible credit-rating downgrade and Brazil’s biggest current-account deficit in 11 years will cause the real to reverse recent gains. Speculators agree, with bearish bets on the currency doubling in a month on Latin America’s main stock exchange to a record $20 billion this week.

“It’s a good time to put the trade back on,” Daniel Brehon, a currency strategist at Deutsche Bank in New York, said in an Oct. 2 phone interview. “Brazil is the most vulnerable in the region.”

While the real received a boost from the Federal Reserve’s surprise Sept. 18 decision to maintain unprecedented monetary stimulus, it has still weakened versus 13 of the 16 most-traded currencies tracked by Bloomberg this year. That’s confounding the efforts of President Dilma Rousseff to soften its drop and bring down the highest inflation expectations in nine years through a $60 billion currency intervention program.

Alan Ruskin, Deutsche Bank’s New York-based global head of Group-of-10 foreign exchange, recommends using options to sell the real against the dollar.

Biggest Advance

Along with the Turkish lira and Malaysian ringgit, Ruskin labeled the currencies as “bad apples” in a Sept. 25 report, saying rising global interest rates will damp growth in countries that experienced “exuberant” lending, which risks increasing the current-account deficit. He said the eventual end of the Fed’s monetary stimulus program will keep emerging-market currencies including the real “under pressure.”

The real was little changed at 2.2073 per dollar at 10:56 a.m. in Sao Paulo. It reached 2.4549 on Aug. 21, the weakest level since December 2008. It gained the most of 16 major currencies in the past month, paring its decline this year to 7 percent, still on pace for a third-straight annual loss.

For a decade through 2010, Brazil, Latin America’s largest economy, embodied the growing power of developing nations along with China, India and Russia, together labeled the BRIC nations. Growth started to sputter in 2011 as a slowdown in China reduced demand for Brazilian commodities including iron ore and soybeans, while Rousseff administration’s increased meddling in the economy sapped investors’ confidence.

Current-Account Gap

The real has tumbled 25 percent since Rousseff, a 65-year-old former Marxist guerrilla, took office in January 2011. Now, facing re-election in October 2014, her challenge is to persuade investors that Moody’s Investors Service was wrong when it lowered its outlook on the nation’s sovereign rating this week.

Morgan Stanley said the real may be hurt by a “further deterioration in external and fiscal accounts,” as well as the potential for Brazil to reduce its currency intervention program to protect exporters, according to an Oct. 2 report by Rashique Rahman, the firm’s head of emerging-market strategy in New York.

The deficit in Brazil’s current account, the broadest measure of trade, jumped to 3.6 percent of gross domestic product in August, the most since 2002, Bloomberg data show. The shortfall leaves the country more dependent on foreign capital.

Money flowing out of Brazil as trade and investment totaled $335 million this year through Sept. 27, after the country attracted $16.8 billion in 2012 and $65 billion in 2011, central bank data show.

Outlook Cut

Moody’s cut Brazil’s Baa2 sovereign rating -- two levels above junk status -- to “stable” from “positive” on Oct. 2, citing the nation’s deteriorating debt and investment ratios and evidence the economy is going through a period of slow growth.

Brazil’s economy expanded less than forecast by analysts in five of the past six quarters and the central bank trimmed its 2013 growth outlook to 2.5 percent from 2.7 percent this week. That’s down from 7.6 percent in 2010, and Moody’s said it would consider cutting the country’s credit rating if it fell into a “low growth trap” of sub-3 percent expansions beyond 2014.

While annualized inflation cooled to a nine-month low of

5.93 percent through mid-September, that may prove short-lived as a weaker exchange rate pushes up the cost of imports.

Consumer prices will increase 6.21 percent over the next 12 months, matching the highest expectations since 2004, according to a central bank survey of economists on Sept. 27. Brazil targets inflation at 4.5 percent, plus or minus two percentage points.

Street Protests

Soaring inflation was one of the triggers that led more than 1 million Brazilians to take to the streets in June in the country’s biggest demonstrations in two decades. The same month, Standard & Poor’s put Brazil’s BBB rating, equivalent to its Moody’s grade, on “negative outlook,” citing “weaker” fiscal policy and a deterioration in the government’s credibility.

“When S&P did the move back in June, we already knew that it’s only a matter of time that Moody’s would take out that positive outlook,” Kenneth Lam, a New York-based Latin America strategist at Citigroup Inc., the second-biggest currency trader, said in a phone interview yesterday. “Brazil’s deteriorating economic matrix has been very well known and been priced in” to the real, he said.

Citigroup in August forecast a level of 2.32 reais per dollar by year-end, which made it more pessimistic than the median estimate in a Bloomberg analyst survey, which sees Brazil’s currency ending 2013 at 2.3 per dollar. In June, the median estimate was for a year-end level of 2 per dollar.

Futures Bets

The value of futures contracts betting that the real will decline versus the dollar was $18.6 billion on Oct. 2, up from $10.9 billion at the end of August, based on data compiled by Sao Paulo-based BM&FBovespa SA, Brazil’s largest stock exchange.

As recently as June, foreign investors had more bets that the real would appreciate than depreciate, according to BM&F. That has shifted as concern grew that rising U.S. bond yields may siphon capital away from Brazil.

The real’s recovery has further to go as the central bank raises interest rates and the economy recovers, said Viktor Szabo, who helps oversee $10 billion of emerging-market assets as a portfolio manager at Aberdeen Asset Management Plc.

“Local rates are one of the most attractive in emerging markets,” Szabo by phone from London Sept. 24.

At 11.79 percent, yields on Brazil’s 10-year government bonds are the highest in the world after Pakistan, according to data compiled by Bloomberg. That compares with 2.63 percent for U.S. Treasuries, up from 1.61 percent on May 1.

Investors Skeptical

Brazil’s central bank has lifted the benchmark interest rate by 1.75 percentage points this year to 9 percent, making it more attractive to hold local assets.

Even as Rousseff pledged to dial back public lending and cut spending twice this year, investors remain skeptical that she will maintain fiscal discipline ahead of the election. The government will miss its target of a budget surplus excluding interest payments equal to 2.3 percent of GDP this year, which was already lowered from 3.1 percent, Citigroup estimates.

With no sign of reforms that will improve productivity before the 2014 vote, the real will decline as rising local costs erode Brazilian industry’s competitiveness, according to Marcela Meirelles, a strategist at TCW Group Inc., which oversees $128 billion.

“At the current level, your potential downside is larger than the upside,” Meirelles said in a phone interview from Los Angeles on Sept. 24. “Brazil needs a weak currency to restore its competitiveness if nothing is done on the reform side.”

Companies are among the losers of the weak real. Gol Linhas Aereas Inteligentes SA, Brazil’s second-largest air carrier by market value, is spending more on jet fuel than any other airline its size in the Americas as the real’s decline boosts imported fuel costs, according to data compiled by Bloomberg. Sugar producer Grupo Virgolino de Oliveira SA’s debt costs have risen for the same reason, data compiled by Bloomberg show.

Companies hedging these risks weigh further on the real, said Italo Lombardi, an economist at Standard Chartered Plc.

“The pressure is pretty high,” he said in a Sept. 26 phone interview from New York. “It’s not like this is over.”