Technicals Highlight Risks Of Significant BRL Weakness

While we maintain a firmly negative stance on the Brazilian real over a multi-quarter time horizon, the prospect of significant intervention by the Banco Central do Brasil (BCB) has kept us from taking an outright bearish stance on the unit in the near term. However, poor technicals and the unit's break through the BRL2.350/US$ level, a recent low, has caused us to question some of our core assumptions for the real in the next few months. Indeed, while we previously suggested that the unit would trade sideways-to-weaker in the near term, the real has depreciated more aggressively than we expected over the past few days ( see 'BRL: Major Downside Limited For Now', November 27).

Sentiment towards the unit has likely turned more negative following a relatively weak Q313 real GDP growth print released on December 3, which indicated that the economy grew by 2.2% year-on-year (y-o-y) between July and September, and contracted by 0.5% in quarter-on-quarter terms, as well as still-weak trade and fiscal data. Moreover, with global financial markets beginning to look set for a period of 'risk-off', we believe further downside could be ahead for the real in the next few weeks, towards the unit's recent low of BRL2.455/US$.

At that point, however, we believe we would see more aggressive intervention by the BCB to stabilise the unit, as was the case in August when the bank announced its US$60bn FX swap auction programme. This is underpinned by our view that significant currency weakness would undermine the BCB's inflation-fighting efforts, and potentially forestall a shift in the bank's agenda towards stimulating growth. Indeed, given our forecasts for real GDP growth to come in at 2.0% in 2013 and 2.5% in 2014, we believe that the BCB would prefer not to prolong the current tightening cycle, which has seen the monetary authorities raise the benchmark Selic target rate by 275bps to 10.00% this year in order to rein in headline inflation and inflation expectations ( see 'Rates To Head Higher Through Early 2014', November 6). As such, we forecast a relatively moderate path for the exchange rate over the coming months, with the unit to average BRL2.300/US$ in 2014, but still notably weaker than our forecast of BRL2.160/US$ in 2013 ( see 'BRL: Fundamentals Point To Further Downside', October 4).

Major Chart Damage
Brazil - Exchange Rate, BRL/US$ (Daily)

Technicals Highlight Risks Of Significant BRL Weakness

While we maintain a firmly negative stance on the Brazilian real over a multi-quarter time horizon, the prospect of significant intervention by the Banco Central do Brasil (BCB) has kept us from taking an outright bearish stance on the unit in the near term. However, poor technicals and the unit's break through the BRL2.350/US$ level, a recent low, has caused us to question some of our core assumptions for the real in the next few months. Indeed, while we previously suggested that the unit would trade sideways-to-weaker in the near term, the real has depreciated more aggressively than we expected over the past few days ( see 'BRL: Major Downside Limited For Now', November 27).

Major Chart Damage
Brazil - Exchange Rate, BRL/US$ (Daily)

Sentiment towards the unit has likely turned more negative following a relatively weak Q313 real GDP growth print released on December 3, which indicated that the economy grew by 2.2% year-on-year (y-o-y) between July and September, and contracted by 0.5% in quarter-on-quarter terms, as well as still-weak trade and fiscal data. Moreover, with global financial markets beginning to look set for a period of 'risk-off', we believe further downside could be ahead for the real in the next few weeks, towards the unit's recent low of BRL2.455/US$.

At that point, however, we believe we would see more aggressive intervention by the BCB to stabilise the unit, as was the case in August when the bank announced its US$60bn FX swap auction programme. This is underpinned by our view that significant currency weakness would undermine the BCB's inflation-fighting efforts, and potentially forestall a shift in the bank's agenda towards stimulating growth. Indeed, given our forecasts for real GDP growth to come in at 2.0% in 2013 and 2.5% in 2014, we believe that the BCB would prefer not to prolong the current tightening cycle, which has seen the monetary authorities raise the benchmark Selic target rate by 275bps to 10.00% this year in order to rein in headline inflation and inflation expectations ( see 'Rates To Head Higher Through Early 2014', November 6). As such, we forecast a relatively moderate path for the exchange rate over the coming months, with the unit to average BRL2.300/US$ in 2014, but still notably weaker than our forecast of BRL2.160/US$ in 2013 ( see 'BRL: Fundamentals Point To Further Downside', October 4).

Key Test Of Support Coming Up
Brazil - Exchange Rate, BRL/US$ (Weekly)

With the weekly chart showing that the real remains in a secular downtrend, we believe that the unit's test of support around BRL2.455/US$ will be key to its medium-term trajectory. A break of this level would suggest a move to trendline support around BRL2.530/US$ in the next few months, and could prompt us to revisit our forecast for the unit to average BRL2.300/US$ in 2014. Moreover, such a move could indicate that our previously highlighted view that the BCB's FX swap auctions will ultimately have diminishing returns could play out sooner than we currently expect ( see 'BRL: Major Downside Limited For Now', November 27). Furthermore, substantial depreciation would have important implications for monetary policy, likely indicating that the central bank will continue its tightening cycle well into H114. This would pose upside risks to our view for another 25bps rate hike to 10.25% in early 2014 before the bank turns its focus to growth in the latter half of the year, in line with our view for 50bps of rate cuts to 9.75% by end-2014 ( see 'Rates To Head Higher Through Early 2014', November 6).

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