Latin American markets came under significant pressure on Monday - with especially the Mexican and Brazilian markets suffering - see “Flash Comment - Emerging Markets: USD weakness spurs turmoil”, published earlier today. We believe there are several arguments supporting especially a further softening of the Brazilian real (BRL) in the coming weeks.

  1. The recent weakening of the USD has triggered nervousness in the LATAM region, and yesterday we saw a weakening of the Brazilian, Mexican and Chilean FX and equity markets. Historically, the BRL tends to overshoot USD weakness. So, when the USD weakens against the EUR, then the BRL tends to weaken against both the EUR and USD.
  2. Growth is subdued in Brazil, and inflation is well within target. We therefore believe, in line with the consensus expectation, that Banco Central do Brasil (BCB) will cut the selic rate tomorrow by another 50bp, from 13.75% to 13.25%. We expect the BCB to continue to cut rates going into next year, eroding the yield pick-up relative to developed markets.
  3. The market has become increasingly concerned about US growth prospects. This is worrying for the Brazilian economy, as the US buys almost 20% of Brazilian exports.
  4. Our technical analysts say the technical picture is increasingly pointing towards BRL weakness. USD/BRL is currently trading at 2.19, but is looking to break through resistance levels at USD/BRL 2.235 within a week. A breakthrough of this level could be followed by a significant move in a weaker direction towards USD/BRL 2.34 within a few weeks. Technical support is found at USD/BRL 2.12.

Recommendation:

We recommend buying USD/BRL via non-deliverable forwards (NDF) with value date December 22, which is currently priced in the 2.19-2.20 range. Our G10 FX strategists see further USD weakening ahead, as the EUR/USD has broken out of the range that has held since May (see FX Crossroads: More upside for EUR/USD - until the US turns, also published today). This could lead to a rally towards EUR/USD 1.35 in the short term. We therefore recommend reducing USD exposure via a long position in EUR/USD.