Brazilian Real Up 5.5% in 2012

NEW YORK ( BBH FX Strategy) -- There is nothing like a 5.5% appreciation of BRL and the Bovespa topping major equity market returns so far this year to focus the mind on Brazil once again.

There were three developments in the last few days worth noting: (1) BACEN cuts as expected but the market seems to be reassessing expectations for cuts later this year; (2) local news wires are talking about further tax cuts coming soon to spur growth in the retail sector; and (3) Finance Minister Mantega is once again talking about measures to stem appreciation of the BRL.

The Brazilian central bank cut rates by 50 basis points to 10.50% as widely expected, keeping the language of the statement unchanged. This suggests that the pace of cuts should remain at 50 basis point rate per meeting for now.

More interestingly, however, markets seem to be reassessing the total amount of SELIC cuts this year. Many local analysts are still calling for rates to fall to 9%. After bottoming out at 9.63% in early December, local swap rates expiring in January 2013 rose 55 basis points to as high as 10.18%, but have since fallen back to 9.88%.

Implied rates in the futures markets are currently pricing a SELIC trough at around 9.75%. But as a result of the recent volatility in local markets, this number has shifted from close to 9.25% to close to 10.0% in recent weeks. We stick with our base case for SELIC at 9.50% for the bottom of the cycle. The next meeting is March 6 and 7, and we should expect another 50 basis point cut to 10% and see how the central bank's language develops.

Part of the reason for the volatility in local rates is the lack of visibility about what growth stimulating measures the government has in store. The latest headlines by the local media suggest that the government is considering a further cut of 0.5% to the tax (IOF) on consumer credit. The government reduced this tax from 3.0% to 2.5% late last year. As we have already noted, President Dilma's government will continue to act along with the central bank by taking measures to spur growth and control the currency.

Indeed, Minister Mantega started once again to talk about measures to stem BRL's appreciation. It is understood that the government has a preference for USD/BRL around the 1.80 level. We see no reason to doubt their resolve to act again and would advise investors to be cautious as we approach the 1.75 level. Late last year, Mantega promised that USD/BRL would not return to 1.60 and so actions will likely intensify as BRL strengthens further.

Around these levels, the risk-reward starts to flip for us and we see a greater chance that BRL will start to underperform other EM currencies. However, implied yields on BRL NDFs remain attractive despite the 200 basis points of total easing seen so far, hovering near the 9.0% level for the 1-month NDF. As we saw back in 2011, a relatively stable BRL coupled with high carry is enough to maintain investor interest in the real, even if outright appreciation is less likely.
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