FxWirePro: Brazilian lira to extend vulnerability ahead BCB’s dovishness – USD/BRL diagonal call ratio spreads on rosy sides

Brazilian central bank is lined up to announce its monetary policy today, following its last rate meeting in late May the Brazilian central bank had signaled that future rate hikes might happen in smaller steps. This more cautious communication was due to political turbulence that was still quite recent at the time.

The Central Bank of Brazil unanimously cut its key Selic rate by 100 basis points to 10.25 percent on May 31st of 2017, as widely anticipated. It is the sixth straight rate decline, bringing borrowing costs to the lowest since December of 2013 amid slowing inflation and a sticky contraction.

Since then things have settled down. At present, it looks as if President Michel Temer will be able to remain in office.

As a result, everyone seems to agree now that the central bank will cut its key rate by a further 100bp to than 9.25% at today’s meeting. And why not? The inflation rate has now reached 3%, i.e. the lower end of the target range and BRL now trades back at pre-crisis levels. At over 7% real interest rates remain very high.

As a result of the central bank still, has some scope for lower key rates. Following 400bp (or probably 500bp after today’s meeting) the question nonetheless arises how much further interest rates can fall now. The market is likely to look for hints on this matter in the central bank’s statement. Everything all told today’s rate decision is likely to be a non-event for BRL.

Should the statement turn out to be dovish this is likely to confirm our view that BRL will probably trend weaker over the coming months. Lower interest rates, weak growth as well as political risks, which mainly affect the outlook for national finances, are causing BRL to become less attractive from an investor’s point of view.

Meanwhile, BRL has underperformed other EM FX, screens cheap on short-term valuation models and spec FX positioning (basis IMMs) at their lowest in a year, prompting an upgrade to OW in the GBI EM portfolio. Even if the hawkish shift in G7 central bank rhetoric prevents full mean-reversion in spot to pre-tape bomb spot levels, we think there is a case here for considering low premium, bullish structures such as 1*2 USD put/BRL call spreads that take advantage of the healthy 3 vol+ implied – realized vol spread and the relative richness of the USD put skew on the surface (refer above chart) without selling the undefined political tail.

Relatively short-tenor (3M and under) tenors are suitable as vol selling targets given the flatness of the vol curve; for instance, 3M 3.20 – 3.10 1*2 USD put/BRL call ratio spreads cost 25bp in premium (spot  ref: 3.2883) for a max payout of 322bp, and 60% discounted to outright USD puts.