The Real Is Cut Loose

Brazil's decision to let its currency float apparently comes after the U.S. and the IMF failed to support Brazil's measures to control depreciation of the real. Brazil has lost about half of its reserves in the past five months trying to defend a level for the real that most economists and observers regard as overvalued. Ironically, even though the decision to allow the currency to float may lead to a larger decline in the real, Brazilian asset markets will likely recover as bargain-hunters step in.

The S&P 500 futures on Globex initially fell on the news, but then sharply recovered. Capital markets in Latin America will also likely slowly recover. The focus will likely be on Argentina, which has extensive trade relations with Brazil. The odds continue to favor the perseverance of the Argentine currency board.

This continues to be the dominant issue in the global capital markets. Capital outflow from Brazil appeared to increase yesterday from Wednesday when the exchange rate regime was adjusted. Preliminary reports suggest almost $1.3 billion left the Brazilian real yesterday via the commercial foreign exchange market. This compares to $864 million fleeing on Wednesday. Flight via the floating market -- mostly tourists and individuals -- is not yet available, but early estimates placed the figure at around another $300 million.

It seems that the ghost of Russia haunts Brazil. Given the material losses and the blow to confidence inflicted by Russian officials last summer, it may seem prudent to expect the worst. After all, in the past couple of years, no country has managed to control the devaluation process once begun. According to press reports, both the U.S. Treasury and the IMF warned Brazil that its accelerated depreciation might not hold. The White House reportedly cautioned that billions of dollars could be wasted defending the new band.

Yet observers trying to paint Brazil with the same brush as Russia are confusing analogy with analysis. Brazil is not Russia by any stretch of the imagination. Brazilians enjoy the rule of law: The rights of contract and property rights are enshrined and protected by law. By most measures, corruption is not nearly as pervasive. While it has further work to do, great strides have been taken in recent years to strengthen the financial system and make industry more competitive. The Brazilian Congress has approved most of the government's reform measures.

While most of the G7 deputies would probably rather discuss the proposals for reference ranges for the major currencies -- for which continental Europe and Japan seem keen -- the Brazilian crisis is likely dominate the meeting. While it is not common for the deputies to issue a statement afterward, given the situation, a formal statement or, at least, supportive remarks for Brazil might occur after the Saturday meeting in Frankfurt.

Contagion remains the chief issue. The fact that many international investors have reduced their emerging market exposure and are not nearly as leveraged, gives reason to believe the contagion may not be as bad this time around, and that it may remain largely localized to the region.

Japanese markets were closed for a public holiday, but most other regional equity markets either rose or saw smaller declines that many had feared after the slide in Latin America and the U.S. yesterday. European bourses are recovering from initial losses.

European bond yields edged lower to new record territory. The benchmark bund yield slipped for its fourth consecutive session and currently stands at 3.64%, a new record low. However, look for yields to back up a bit early next week ahead of Germany's sale of about $5.8 billion in new 30-year bonds.

The dollar is holding its own today against the euro. Over the past few sessions, the euro has gravitated around the $1.1660 level. The dollar has pulled back from just below the 114-yen level. Support is seen near 112 now and a break would signal a move back to the 110.50-111.00 area. Sterling and the Swiss franc appear to have been buoyed by safe-haven flows.

Market-moving news from Europe has been light and participants await the opening of North and South American markets today for leadership. Italy did report November industrial output. The 1.5% decline posted for the month was nearly twice the decline the market had expected. On a year-over-year basis, industrial output has contracted by 0.5% in Italy.

The U.S. is set to report industrial production, capacity utilization and import/export prices. Only industrial production will draw attention. Although NAPM and the recent jobs data warn of continued weakness in the manufacturing sector, industrial production is forecast to have risen by about 0.3%, reversing the decline recorded in November.

Several Federal Reserve officials and Treasury Secretary Rubin will be speaking today. Their comments might affect the financial markets, where liquidity is likely to dry up quickly after the data, given that several U.S. markets will close early today ahead of Monday's holiday.