Thursday, March 26, 2009

Brazilian real carry trade

As we have noted before in part 1 of the carry trade series, the carry trade is essentially a negatively skewed asset class as carry traders smooth out the typical fluctuations until liquidity concerns and/or risk appetite decreases and everyone heads for the door at the same time. Below, we have the AUD/JPY spot since 2005:

In the current environment, with ongoing liquidity problems, decreased risk appetite, high volatility and drastic central bank actions it would seem suicidal to consider any kind of carry trade for a while. Additionally investors are currently extremely gun shy about emerging markets, seeming almost reflexively due to the current bunker mentality.

On Tuesday, Banco Central do Brasil released the external accounts results for February, which provides great fodder to examine BRL as an investment currency.

Rate spreads

The BRL overnight rate is currently at 11.25% after dropping 1.5% earlier this month. At first glance, it seems likely that the BCB will drop the rate given the inflation numbers being under target and the global depression looming. However even given that, the final rate is targeted to hit 9% by late 2009; rising commodities prices and increased foreign capital are expected to temper the central rate. With the neither dollar or yen unlikely to move much for the rest of the year, the spread is likely to remain pretty healthy.

Currency risk

The Brazilian real is currently somewhat historically weak compared to the dollar, but given the outlook for the dollar going forward it's not unrealistic to see the real appreciate against the dollar. Specifically with US->Brazil FDI being ~6.5x of the reverse, and that number only going to go higher as emerging markets return, there seems to be room for the real to gain some ground. It's important to note in the above graph, the currency hump from roughly mid '02 to mid '05 was due to the hyperinflation of the time (e.g. ~17.25 % in May '03). Additionally, current account numbers shrunk by ~43.5% YTD on a month to month basis from 2008 and a trend of Banco Central open market spot and repo interventions over the past 6 months to strengthen the real are strong indicators going forward.


There are a lot of potential minefields out for the real as a funding currency. Lower commodity prices, a sudden dive back to safe haven currencies and fluctuation in inflation numbers all have the potential to squeeze the spread on carrying the real. Additionally the giant wave of predicted inflation in the US is a huge risk, somewhat mitigated if the yen is used instead. The real is also not the most liquid cross - open interest is laughably small compared even to the peso. Given all that, it is worth exploring in more detail.
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