Brazil’s Currency Bulls Now Getting Burned by Political Mess

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  • Investors want to see progress in Temer’s ambitious agenda
  • Analysts see rally fading, currency stabalizing by year-end

The world’s best currency rally has lost its mojo.

Brazil’s real has been falling in recent weeks, and is now barely hanging on as 2016’s top performer. Bears are reemerging as a fractured Congress, feuding politicians and a stew of corruption dims hopes President Michel Temer will succeed in pushing through reforms to shore up the budget, restore business confidence and pull the country out of its deepest recession in a century.

It wasn’t supposed to be this way. The currency soared 23 percent in the first half of the year on bets then-President Dilma Rousseff would be ousted and a new administration would get the country back on track. But as impeachment turned from wishful thinking into reality -- with Rousseff officially thrown out last month -- early hiccups in the new government and a dim outlook for legislative measures sent the real lower, making it the second-worst performer in Latin America since it reached a 13-month high on Aug. 10.

"The market has been overly optimistic about the consequences of Rousseff’s removal," said Arnaud Masset, an analyst at Swissquote Bank SA in Gland, Switzerland, and one of the top five forecasters for the real last quarter. "On the data side nothing has changed, and the new government will just inherit the challenges of the previous one."

Shrinking Economy

Those challenges include an economy that’s forecast to contract 3.4 percent this year after shrinking 3.8 percent in 2015, inflation that’s been above the midpoint of the central bank’s target for six years, and record unemployment of 11.6 percent. While growth is forecast to return next year and bond traders are betting inflation has peaked, the fundamental problems that got Brazil into this situation remain, namely lower commodity prices, a government that’s heavily involved in the economy, and public spending that exceeds revenue.

Brazil’s situation shows that even as investors generally remain bullish on emerging-market currencies amid wagers that interest rates will remain suppressed in developed countries, local issues are taking the shine off some exchange rates. Mexico’s peso has plunged to a record low as polls showed increased support for U.S. presidential candidate Donald Trump, who has pledged to renegotiate trade deals, and South Africa’s rand has tumbled amid government turmoil.

In Brazil, investors have increased bearish bets against the real to $17 billion. While that’s less than half the peak they reached in May of last year, it’s up from $13.9 billion earlier this month.

Bullish Position

Morgan Stanley is keeping its bullish position on the currency, and said Friday the recent dip in the real might be a good moment to buy, even with the policy risk. The currency had declined 4.2 percent since Aug. 10 to 3.2617 per dollar as of 12:46 p.m. in New York on Monday. That has trimmed its gain this year to 21.5 percent.

While strategists were consistently raising their forecasts for the real for most of this year, the optimism abated in recent weeks. Predictions for the real’s level at the end of March 2017 rose every month this year until September, when they practically flatlined. The real will weaken 2.6 percent by year-end and 4.6 percent by the middle of 2017, according to the median estimate of analysts surveyed by Bloomberg.

Traders in real options have also curbed their optimism in the last week. The three-month 25-delta risk-reversal, a measure of the premium for the right to sell reais over the right to buy, rose to 2.585 percentage points Friday from 2.25 percentage points on Sept. 8.

Selloff Temporary

"It would be fanciful to expect the real to continue to strengthen at the same pace as it did in the period from January to August," said Per Hammarlund, chief emerging-market strategist at SEB SA in Stockholm, who called the surge in the real earlier this year and forecasts the currency will be at 3.25 per dollar by mid-2017.“A selloff from here will likely be temporary, because weakness will likely discipline lawmakers to support the government’s reform program, even if they try to water it down a bit.”

Temer’s plan includes unpopular measures to tame the government’s finances and rewrite social security and labor laws to be more favorable to businesses. To get that done, the president has to navigate a fragmented Congress with representatives from more than 25 political parties, all pushing their own agenda before local elections in October.

Changed, Delayed

The austerity measures have already led to spats. The bill to limit increases in public spending, presented in June and seen as one of the cornerstones of Temer’s agenda, has been changed and delayed -- the latest estimate for voting is November. The proposals for social security reform and labor reform are also on hold.

Then there’s the economy, where data remains mixed. While consumer confidence has been improving since May, retail sales fell more than expected by analysts in July, the worst performance for that month in 15 years.

"We’ve had a mammoth rally this year, with a lot of good news priced in already. Now we turn our attention back to fundamentals and policy," said Mike Moran, head of economic research for the Americas at Standard Chartered Plc, which gets more than half of its revenue from emerging markets. "This was always going to be the hard part."