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)

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Related sectors of this article: Economy, Finance, Forex
Geography: Latin America, Brazil, Colombia, Mexico

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