Brazilian Real Skids Back Towards Record Lows

In keeping with the theme encircling emerging markets, Brazil’s economy is feeling the full impact of weak trade, rampant commodity deflation, and political disaster.  In the wake of retreating trade with China and plunging prices for key exports such as oil and iron ore, the economy has undergone a rapid contraction.  An ongoing Government corruption probe also threatens to bring down the incumbents as the nation works desperately to clean up its image ahead of the summer Olympics.  With commodity prices unlikely to rebound in the near-term and unemployment on the rise, the outlook for the Brazilian Lira and economy at large is ripe for further deterioration at a time when the nation can ill afford to handle other creeping complications.

Tumbling Exports Feed Unemployment

Since peaking in 2011, Brazilian exports have gradually fallen over time, matching in many ways the 44-straight months of producer price deflation in China as other emerging export economies feel the pinch of weaker demand.  China is Brazil’s single largest trading partner followed by the United States as the next largest counterparty at just over half the trade volume as China.   As an export-oriented economy, raw materials account for 46.00% of total exports with manufactured goods numbering 38.00%.  Trade is a shadow of its former self, falling from a record $5.63 billion in May of 2013 to a modest $1.53 billion in the latest monthly reading from 2015.

During the last year, unemployment has moved sharply higher as worsening economic conditions have spun out of control as evidenced by the widespread contraction throughout the nation.  Brazil has seen gross domestic product collapse at an accelerating rate, shrinking at -4.50% annualized rate according to the latest reading.  The economy is firmly entrenched in a recession, with quarterly GDP figures falling the first three quarters of 2015.  The retreat in commodity prices and trade has yet to reverse with Brent crude oil prices falling -41.74% in the last year while iron ore fell by nearly -40.00% in 2015, continuing to slide since the outset of 2016.  Since then, unemployment has risen from 5.30% in January of 2015 to the present 7.50%, the lowest levels since the 2008-2009 financial crisis.

Policymakers Stuck With Stagflation

Although unemployment has pulled back modestly from 2015 highs of 7.90%, the slide in the Brazilian Real has had a disastrous impact on the economy, leading inflation back above 10.00% with the annualized pace for 2015 at 10.67% year over year. When combined with high inflation and high interest rates which currently sit at 14.25%, policymakers are stuck high and dry in a textbook stagflation scenario of high unemployment, high inflation, and low growth (or contraction in Brazil’s case).  Raising interest rates further to tackle inflation might end up translating to weaker growth overall on top of a recessionary environment.  Lower interest rates to accommodative growth will likely to translate to additional losses in the Real, meaning higher inflation.  The current scenario is a “catch-22” moment in that any action undertaken by policymakers is likely to have a negative impact.

Without a prolonged rebound in commodity prices and revival of the export economy, the Brazilian Real is expected to plunge back towards record lows hit back in September, especially as the pace of capital outflows from emerging markets sees a pickup thanks to a flight to quality assets versus higher yielding instruments.  The Federal Reserve’s exit from crisis-drive monetary policy is seeing increased flows back into the US dollar, pushing up the value of the currency and hurting emerging economies that borrowed heavily in Dollars during the period of ultra-low rates.  Continued policy normalization from the United States is likely to prove an additional tailwind pushing the USDBRL pair higher over time as persistent weakness in the Brazilian economy drives the currency back to the brink.

Technically Speaking

Since pulling back from record highs reached back in September, the USDBRL currency pair has been back on the march to the upside amid the monetary policy divergence and growing concerns about the worsening outlook for the Brazilian economy.  The “golden cross” technical pattern that emerged back in September of 2014 continues be a strong catalyst of bullish momentum in the pair after the 50-day moving average crossed the 200-day moving average to the upside in a traditionally strong signal.  Key resistance on the upside currently sits at 4.2487, the most recent high for the pair with any candlestick close above this level considered an additional bullish indication.

On a more short-term basis, USDBRL is once again moving higher after the pullback from September highs, with the emergence of an upward trending equidistant channel pattern adding to an already strong bullish bias.  Ideally, investors looking to take advantage of the slide in the Real should be quick to execute long positions at the lower channel line, targeting the upper channel line for an exit.  Even though the USDBRL is forecast to continue declining owing to the host of fundamental and technical factors, chasing after upward momentum could prove disastrous especially as volatility picks up.

The Outlook

As Brazilian economic fundamentals continue to disintegrate, the Real will face ongoing pressure and likely underperformance owing to the worsening outlook.  An ongoing investigation into the Government will prevent any form of near-term fiscal stimulus while the Central Bank will be forced to take a pause on monetary policy owing to continued stagflation.  The only upside in the Real will come from more aggressive tightening of interest rates or a sustained rally in commodity prices, both of which are highly unlikely.  As such, finding a promising dip in USDBRL makes for an excellent entry point on a longer-term basis with the pair likely to hit new multi-year lows in the coming weeks.

This article was written by Idan Levitov, Head analyst for anyoption.com