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Raising the Stakes in Brazil

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Ilan Solot

NEW YORK ( BBH FX Strategy) -- The board is set, and the chips are stacking up for foreign exchange and interest rate bets in Brazil.

On the currency war front, officials are growing more bellicose around the dollar/real 1.70 (spot) trench in response to growing market conviction that a sustainable break below the key level is forthcoming.

The government is raising the stakes. The central bank remains at the front line with spot and foreign exchange swap interventions, and the bigger guns are coming out after the USD/BRL currency pair closed at less than 1.70 Tuesday for the first time since October.

Tuesday evening, Treasury Secretary Arno Augustin stated that the sovereign wealth fund is ready to be used to contain BRL strength.

The secretary also reminded markets that the fund's potential USD buying power is theoretically unlimited. On Wednesday, officials are again warning of more foreign exchange measures. Some possibilities include reintroducing the IOF on foreign equity investment as well as raising the tax on derivatives.

We have no doubts the Treasury is willing to act to stem BRL appreciation, but we are less sure about the odds of it working.

The best that the authorities can do is to slow down the pace of appreciation, in our view.

Inflows are still largely driven by fundamentals (massive FDI numbers) and prospects of continued high carry (even if SELIC falls to 9.00% later this year).

As such, the risk rewards for being short USD/BRL at these levels depends largely on investors' time frame.

In the short term, BRL will get very choppy until it makes a clean break of 1.70. In the meantime, we think there are better ways to express outright positive emerging-market foreign exchange views. They include the Mexican peso, Polish zloty, ruble, and won.

For a longer-term investment, however, the carry and prospects of gradual appreciation are very favorable.

Despite 200 basis points of easing already and another 150 basis points of easing on deck, implied yields remain high.

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