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 one-month BRL nondeliverable forward implied yield around 9% is still about as high as it was last August, when COPOM (the monetary policy committee of Brazil's central bank) first started cutting rates. After the 1.70 level, other near-term targets are 1.67 (October 2011 lows) and then 1.65. On the rates front, markets have all but convinced themselves that SELIC rates will reach 9.00% by the middle of the year, having also fully committed to the short-end receiving rates trade. By default, this leaves the market in a poor technical position to deal with surprises pointing the other way. Surprises could come in the form of (1) unexpectedly stronger economic data (2) fiscal slippage; or (3) a change in communication showing greater concerns about inflation, implying less or slower rate cuts. Since (1) and (2) are far (far!) more likely than the (3), we think the best way to position for the risk of a surprise is through curve steepening trades. This is especially true because (1) and/or (2) may not trigger the (3). We update our end of cycle SELIC rate expectations from last year's forecast of "9.50% with a lower bias" to 9.00%-9.25% in light of recent data and official communication. The next COPOM meeting is March 6/7, with markets looking for another 50-basis-point cut to 10%. The communication emphasis will change somewhat, but the end result is basically swapping one set of dovish arguments for another. To keep up the dovish tone, central bank President Alexandre Antonio Tombini seems to be relying less on external risks and more on the view that Brazil's "neutral interest rate" are declining. Turning to fundamentals, lending data released Tuesday showed that there is little to get excited about: New loans to corporates fell while those to consumers rose, but overall lending decelerated from 19.0% in December to 18.4% in January. The data strengthen the case for further easing, especially by loosening macroprudential measures. Ahead of the COPOM meeting, we will get a look at fourth-quarter GDP, February PMI and trade and January industrial production.
All are expected to show continued slowing, which will underscore COPOM's dovish stance. On the fiscal front, the government posted a higher-than-expected budget surplus of 20.8 billion reals (vs. expectations of 18.8 billion reals). We think the government is serious about carrying through fiscal tightening to allow more space for monetary easing, but we are not yet convinced they can do so. Recall that the minimum wage will increase substantially this year and that President Dilma Rousseff's industrial policy initiatives come with a hefty price tag.