FX Dashboard: Brazilian Assets Build Risk Premia

After weakening late in the day yesterday, the dollar index (DXY) recovered this morning to end up at 91.0, circling back to where it started. Most importantly, DXY is still within its trading range of 89.5-91.5, although it is now close to the top end of the range.

EM currencies, however, continued to grind lower as they weakened by 0.2% this morning. The Mexican peso (MXN) and the Turkish lira (TRY) led the way with both depreciating around 1% each. In terms of regions, Asia performed quite well as the currencies in the region strengthened by 0.2% on average in contrast with 0.6% average depreciation for Latin American currencies.

Among Latin American currencies, while the Brazilian real (BRL) was not the worst performer, it still garnered all the attention as the market waits in anticipation of the senate voting on an emergency bill to extend cash handouts. This is on the heels of the Q4 GDP release this morning, which surprised on the upside as it implied a full-year contraction of 4.1% in 2020, better than most of its peers in Latin America. The pressure to approve the emergency bill is high as the impact of the last fiscal aid package fades amid rising Covid-19 cases.

Fiscal concerns have risen because compensatory measures included in the bill have been watered down as the senate mulls excluding some of the expenditures from the spending cap rule. Thus, in effect, making the rule moot. This is critical as the budget deficit was almost 14% last year and is set to remain high at above 7% in 2021, according to Bloomberg consensus forecasts, with public debt approaching 100% of GDP. The fate of the market-friendly Economy Minister, Paulo Guedes, is also being attached to the bill because even if he stays in office, it will be clear that his influence has waned.

As we have discussed in our previous notes (see here and here), Brazilian assets are already reflecting the fiscal risks. BRL, for example, has weakened almost 10% this year and is not far from the worst levels of March last year. Not surprisingly, in an environment of rising risk aversion, the correlation of long-end rates with BRL has risen considerably, with the two moving almost in sync with each other now as the chart below shows.

More concerning though is the rise in short-end rates. The curve is now pricing in hikes of almost 400 bp in 2021 alone and between 50 and 75 bp increase in the benchmark rate at the next meeting on March 17. Inflation expectations have been rising with the year-end forecast based on the central bank survey increasing to 3.87%, above the central bank’s year-end target of 3.75% but within the 1.5% band on either side of the target. However, compared with the rise in inflation, the rate hikes being priced look excessive and the market is likely pricing in high uncertainty in the short end as well.

Despite the high risk premia already built in Brazilian assets, we choose to stay on the sidelines for the time being as the risks are significant and binary.

Data Source: Refinitiv

Best Longs / Best Shorts

• To our list of underperformers in the attached FX Dashboard pdf, we added the Polish zloty against the euro (EURPLN) as its z-score based on 3m changes crossed 1. We continue to like being Long PLN vs Short Czech koruna (CZK) (see here and here).
• While the z-score for BRL exceeded 1 as well, we did not include it on our list of underperformers for reasons discussed above.
• The list of outperformers stayed the same with the Taiwan dollar (TWD) on it. Indeed, TWD looks more expensive than previously with its z-score approaching 2.

Best Crosses

• Our list of preferred relative-value trades shrank further as it now consists of Long MXN vs Short the Australian dollar (AUD) or the British pound (GBP).
• The 3m expected returns for these pairs have dropped but are still high in the range of 8.0-10.0% (not annualized), assuming mean reversion.