Brazil's currency has been racing higher, but this analyst reckons its golden run is over

Photo by Laurence Griffiths/Getty Images

While it’s yet to feature heavily in the Olympic medal standings, collecting a gold and bronze medal to date, Brazil’s currency — the real — has put in a gold medal performance so far in 2016.

From the lows of late January, it’s rocketed by over 30 against the US dollar, mirroring the recovery in other asset classes, including its two main commodity exports, iron ore and oil.

It is now the strongest that it’s been in close to 12 months, a stark change in fortune from recent years when it was under intense selling pressure.

To many, the real is looking like the real deal at present.

David Rees, a senior markets economist at Capital Economics, believes there’s a simple explanation to explain the real’s rise: commodity prices are higher, investors are searching for yield and there’s signs that Brazil’s crippling recession is now past its nadir.

“Investors are likely to have been buoyed by clearer signs that the economy is now clawing its way out of recession, and ultra-low yields in the developed world have driven a general migration into emerging markets,” he wrote in a research note released on Tuesday.

However, while he believes “Brazil is undoubtedly in a better position now than it was a year ago”, Rees believes the real’s breakneck rally has left it vulnerable to a correction in the months ahead.

“The most recent gains have not been justified by commodity prices, and we do not expect these to offer much support in months ahead either,” says Rees.

“Admittedly, it is not unusual for the real to break away from commodity prices, but we suspect that optimism regarding the economy may also be overdone. While the economy does appear to have turned a corner, a prolonged period of strong growth seems unlikely – particularly as the government struggles to deal with Brazil’s dreadful debt dynamics.”

The chart below from Rees tracks the USD/BRL versus movements in crude oil and iron ore so far in 2016. The scale for the currency is inverted.

Along with overoptimism towards the economic outlook, Rees believes another consideration that is being overlooked is the potential for another US interest rate hike.

“We still think investors are drastically underestimating the prospects for monetary policy tightening in the US, and continue to expect the FOMC to push the button on another rate hike before the end of this year,” he says.

“That would probably cause the dollar to appreciate across the board and also see investors head back out of emerging markets.”

Though he doesn’t expect the real to “return to the dark days of 2013-15” when it was in “freefall”, Rees believes it could fall by over 10% before the year is out.

“We would not be surprised to see the real to give up some of its recent gains, and perhaps weaken towards 3.60/$ before year-end,” he says.

The USD/BRL currently buys 3.1683.

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