Rising Treasury Yields To Stymie BRL Strength

Recent strength in the Brazilian real will give way to renewed depreciation in the coming months. The primary driver of the depreciation will be higher treasury yields in the US, as the US economy picks up. High frequency data from the last several weeks have reinforced our view that the US economic recovery is back on track, which we expect to trigger a sell-off in treasuries as markets begin to anticipate more hawkish policy from the Fed.

Rising yields in the US will see investors increasingly differentiate between Latin American assets, including currencies, based on macroeconomic fundamentals. This will spell downside for the real, as investor concerns over Brazil's sluggish growth, deteriorating government fiscal accounts and large current account deficit prompt further capital outflows. In contrast, those countries that are exposed to strengthening US growth, namely Mexico and Colombia, will see additional upside for their currencies this year. As such, we expect the regional outperformance of the real in the year-to-date - up 5.2% against the US dollar - to dissipate going forward.

Moreover, while the Banco Central do Brasil (BCB)'s aggressive hiking cycle has also played a role in the real's recent outperformance against other Latin American currencies, we see monetary policy dynamics in the region shifting in the coming months. We forecast only one more 25 basis points rate hike in Brazil to 11.25%, before the BCB shifts its focus to stimulating economic growth and cuts rates to 10.75% by year-end. Meanwhile, we forecast rate hikes in Mexico and Colombia in 2014 (the latter of which has already commenced upon a tightening cycle), reducing the interest rate differential between the real and more fundamentally sound currencies, and helping to stymie its recent outperformance.

US Economic Improvement To Drive Downside For BRL
Exchange Rate, BRL/USD And US Generic 10-Year Treasury Yield (LHS) & BRL/USD (RHS)

Rising Treasury Yields To Stymie BRL Strength

Recent strength in the Brazilian real will give way to renewed depreciation in the coming months. The primary driver of the depreciation will be higher treasury yields in the US, as the US economy picks up. High frequency data from the last several weeks have reinforced our view that the US economic recovery is back on track, which we expect to trigger a sell-off in treasuries as markets begin to anticipate more hawkish policy from the Fed.

Rising yields in the US will see investors increasingly differentiate between Latin American assets, including currencies, based on macroeconomic fundamentals. This will spell downside for the real, as investor concerns over Brazil's sluggish growth, deteriorating government fiscal accounts and large current account deficit prompt further capital outflows. In contrast, those countries that are exposed to strengthening US growth, namely Mexico and Colombia, will see additional upside for their currencies this year. As such, we expect the regional outperformance of the real in the year-to-date - up 5.2% against the US dollar - to dissipate going forward.

US Economic Improvement To Drive Downside For BRL
Exchange Rate, BRL/USD And US Generic 10-Year Treasury Yield (LHS) & BRL/USD (RHS)

Moreover, while the Banco Central do Brasil (BCB)'s aggressive hiking cycle has also played a role in the real's recent outperformance against other Latin American currencies, we see monetary policy dynamics in the region shifting in the coming months. We forecast only one more 25 basis points rate hike in Brazil to 11.25%, before the BCB shifts its focus to stimulating economic growth and cuts rates to 10.75% by year-end. Meanwhile, we forecast rate hikes in Mexico and Colombia in 2014 (the latter of which has already commenced upon a tightening cycle), reducing the interest rate differential between the real and more fundamentally sound currencies, and helping to stymie its recent outperformance.

The technical picture on the real also points to downside from present levels. The unit has bounced off key resistance around BRL2.19/USD in recent trading, a bearish signal that could indicate substantial downside of 8.6% towards support around BRL2.45/USD, a level that has been previously tested during spikes in US yields.

BMI Americas Asset Class Strategy Table
DATE INITIATED ENTRY LEVEL GAIN/LOSS RATIONALE
CURRENCIES
Bearish CAD vs GBP 23-Sep-13 1.649 12.43% Key technical break in favour of GBP is complemented by a strengthening UK economy, while Canadian growth will face headwinds given potential for a softer housing market and the country's exposure to a China slowdown.
FIXED INCOME
N/A
EQUITY INDICES
Eurozone Over US Equities (Ratio of MSCI US to MSCI EMU) 15-Aug-13 17.30 1.33% Though we still like the US, eurozone underperformance has reached extremes, and the eurozone economy is picking up momentum. The MSCI EMU looks attractive on a technical basis and is increasingly cheap versus the US. Targeting a move down in the US/EMU ratio to 14.0x.
Mexico's IPC Over Chile's IPSA 20-Mar-14 10.80 -2.35% Mexican equities will benefit from strong economic integration with the US while Chile's economy will continue to face headwinds from softening Chinese demand for industrial metals.
Bearish Brazilian Equities 9-Apr-14 51,103 -0.37% A false break through resistance, overstretched momentum indicators and weak fundamentals inform our view that the relief rally in Brazil's benchmark Bovespa equity index is running out steam. As such, we target a move back towards key support at 45,000.
MACRO/INDUSTRY STRATEGY
Bullish North American Palladium Producers 19-Mar-14 15.19 3.29% We expect that higher palladium prices, due to supply constraints in South Africa and Russia, as well as strong demand from the autos sectors in the US and Mexico will bolster North American palladium producers, particularly Stillwater.
Source: Bloomberg, BMI; Updated April 28 2014.
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