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The BRL should depreciate on a spot basis over the next year, and positive carry should largely cover the spot losses. A number of factors have helped the BRL. These range from improvement in macro data (bottoming out GDP growth, low inflation, and improvement in twin deficits), the real yields within EM, a positive surprise from political negotiations and higher commodity prices. However, these factors have also taken the currency beyond its fair value relative to commodity prices.
The major driving forces: Structural reform hopes are alive with President Temer’s graft case on the back burner. Economic strength should continue to bring more FDI flows and high real yields should entice foreign investors towards debt. However, positioning seems heavy, which limits the downside in the pair.
Risk profile: Impediment to pension reform progress, higher UST yields or a commodity price sell-off could lead to an unwinding of long BRL positions.
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 (at spot reference: 3.1233) for a max payout of 322bp, and 60% discounted to outright USD puts.
