FxWirePro: Deploy Directional Structures For USD/BRL On Hopes Of Further BCB Cuts

Last week, the Brazilian central bank cut its key interest rate by 75 bps to 2.25%. Remarkably, it left the door open for another small cut in its accompanying statement. And this despite the fact that in May there was still talk of a final rate cut.

However, this is not the first time that the central bank has been too hasty in signaling the end of the rate cuts. Ultimately, this reflects the dilemma of the central bank. The leeway for further rate cuts is pretty much exhausted. According to the minutes of the meeting, which were published yesterday, the level from which further rate cuts could lead to instability in the financial markets has almost been reached, due to the fragile state of public finances. Whether and if so how much, the central bank will continue to cut its key interest rate seems almost secondary. What is likely to be decisive for the FX market is that the central bank concedes in principle that it has hardly any room for maneuver left, and this despite the fact that the country is in a severe crisis. The uncertainty surrounding the corona pandemic remains high, especially in Brazil, as the virus is still spreading rapidly. Against this background, investors are likely to remain cautious and the BRL is likely to remain weak.

The Central Bank of Brazil outlined details of its private sector bond-buying program on the secondary market in a statement released on June 23rd 2020. The program aims to provide liquidity in the corporate bond market and to tackle potential dysfunctions amid the coronavirus crisis. Assets with a credit rating equivalent to "BB-" or higher, which are non-convertible into shares and have a maturity of at least 12 months, will be eligible for purchase taking into account the reference prices published by Anbima and B3. The bank added that there will be limits in the portfolio per issuer, per series of assets in the market, and in relation to the risk classes of the assets in order to better control risk.

Well, we advocated playing the USD-lower theme in the recent past in EM-bloc that is supported by the favorable rates differentials, still, cheap EM valuations with respect to other asset classes that have enjoyed more sustained recovery, although the sensitivity of EM Carry plays to local idiosyncrasies, global sentiment and (indeed) USD directionality requires some care when structuring the trades. We have noted earlier on the relative expensiveness of EM vols and skews vs. G10 ones. Despite the large move in spot, a more granular analysis finds an even bigger dislocation on the pricing of the USDBRL skew, based on a linear relationship comparing changes of riskies pricing vs. spot moves, both measured over 3M horizons. Keeping in mind that the country, and the Latam region in general, is still experiencing the most acute phase of the health crisis, lagging Europe by 1-2 months, and the fact that the currency has experienced a 25% vs USD YTD, the medium-term fundamentals remain better supportive for Brazil than other EM countries with large fiscal deficits and/or weak BoP position.

That said, rather than entering an outright short risk-reversal trade, fully exposed both in spot and vol terms to an inversion in market sentiment, we add a long OTM USD call/BRL put to the 25-delta risk reversals for capping the maximum loss the structure can suffer. 

Trade tips:

Long 3M USDBRL 25-delta USD put/BRL call, short a 25-delta/10delta USD call/BRL put spread @ USD 0.2% (spot ref. 5.24, strikes 4.842/5.508/6.052). Courtesy: JPM  & Commerzbank

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