FxWirePro: Capital flows to intensify Brazilian currency but politics and fiscal deficit still a taboo - USDBRL topside seagull to solve the riddle

Even though the high-yielding currencies have become consensus trades for 2018, we maintain a more bullish stance than consensus on BRL short term. The significant improvement in capital flows linked to the growth boost we expect in 2018 should support BRL.

On the other hand, though we assume that a market-friendly candidate will become Brazil's next president, the lack of clarity is certain to weigh on foreign and local investor sentiment alike; we believe however investors to begin converging on this dynamic closer to 2Q’18.

The major risk to our rates views we reckon stems from mounting debt caused by the fiscal deficit and Brazil's reliance on non-recurring revenues (such as concessions of infrastructure services) to meet the primary balance target, which we believe remains manageable for now considering the starting point and the BCB's large FX reserves.

Thus, 6m USDBRL topside seagull (strikes 3.10/3.40/3.60): The structure is a standard 6m call spread that is partly financed by selling a put strike 3.10 (reduces the cost of the call spread by 70%) and maximum leverage is 8x (5% gain at expiry).

The loss is unlimited below 3.10. Positioning in local rates is very high, supported by disinflationary pressures, BCB easing, high real yields and an improving external position.

However, in 2018, BCB is expected to end its easing cycle and tighten in 4Q’18, while political risks will intensify leading up to the October elections with the nagging issue of pension reform likely unresolved.

For USDBRL to trade meaningfully below the 3.05-3.10 lows on a sustained basis would require a perfect storm of domestic and external factors aligning.