The analysis team at Nomura explains that Brazil’s political and long-term (LT) economic policy U-turn witnessed last year had market-friendly political stability as its cornerstone and that premise may no longer be valid, at least in the short term (ST).
“At this juncture, most of the outcomes that we can envisage at the moment lead to negative market outcomes. Even if the government manages to survive the allegations that are circulating in the press, the government’s defense strategy is likely to leave markets with more questions than answers which, unfortunately, will probably not heal until there is a new administration, regardless if this happens soon or not until October 2018.”
“Add another recession in the interim, and friendly political parties leaving the government coalition and both cyclical and structural trends are likely to remain weak at best. The real danger is that, with the absence of confidence in the long term, the sustainability of Brazil might come under scrutiny once again until LT politically stable solutions are put in place. Even if we assume a solution can be found, pain should be inevitable at this point, with no easy solution in the ST. We were expecting a pick-up in volatility and also acknowledged that there were credible tail risks that were not to be ignored in the last two months. Given the extent of BRL’s rally at the time, coupled with the fact that implied volatility levels had fallen significantly, we saw USDBRL strangles as attractive vehicles to hedge against two-way risks.”
“FX-wise, we think BRL is likely to continue suffering. A month from now, we think this will likely still be the case, and thus finding a way to be long USD makes sense. However, we need to consider the daily volatility in returns as intraday actions from the central bank (selling FX swaps, spot, USD lines of credit, etc.) make outright long USD positions difficult to keep. USD call options make sense for us here, even if the spike in implied vol makes them look expensive now. One thing we learned from the political storm that led to the eventual impeachment is that markets could also price improvement very quickly, and thus identifying these make or break points is extremely difficult. Think here of a clean and fast political transition where a pragmatic administration takes over. The risk is of a quick improvement in asset prices that would make unwinding of bearish positions very difficult. This example reinforces our view of using options to engage these markets.”