Election uncertainty drives volatility in Brazil markets
Brazilian assets have grown more sensitive to shifts in election polling
Divulgação
After a relatively calm stretch and broadly positive sentiment from late August through the first half of September, Brazilian assets are entering a more volatile phase.
The real and local interest rates have continued to outperform peers, but with the first round of the presidential election approaching, investors are preparing for a period in which even small shifts in perceptions of the race could trigger outsized price moves.
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That helps explain why some banks remain neutral on Brazilian markets, recommending only hedged positions or trades they believe can perform regardless of the election outcome. Others are simply watching domestic assets to gauge what is already priced in and identify potential asymmetries after the vote.
Election sensitivity
So far, the sharpest compression in risk premiums has come in the interest-rate market. After being seen as the “ugly duckling” of Brazilian assets since the outbreak of the war in Iran, DI (Interbank Deposit) futures have rallied strongly as perceptions of a tighter presidential race have taken hold.
Between mid-August and Friday, longer-term rates fell by around 0.5 percentage point even as global yields surged. The exchange rate per U.S. dollar, meanwhile, remained between R$5.10 and R$5.15 despite broad gains in the U.S. currency.
Shifting expectations about the election have therefore helped contain the impact of a worsening external backdrop. From here, however, investors are bracing for greater volatility, with markets increasingly tied to the next tracking polls and voter-intention surveys.
“The markets are still not pricing either election outcome,” said Andrea Kiguel, Barclays’s FX and rates strategist for the Americas. “We believe markets should continue to price an uncertain outcome through the first round, as the polls point to a tight runoff, with the gap between the candidates within the margin of error.”
Over the weekend, Senator Flávio Bolsonaro of the Liberal Party moved ahead of President Luiz Inácio Lula da Silva of the Workers’ Party in overseas prediction markets, which are prohibited in Brazil.
That could provide some support for Brazilian assets, although market participants do not expect a major reaction for now because of uncertainty over the next tracking surveys and opinion polls, which São Paulo’s Faria Lima financial district is watching closely.
Rate scenarios
Barclays currently has no directional position in Brazilian assets. Depending on the election outcome, however, Kiguel sees scope for a sharp rally, while cautioning that the move could become excessive.
In a scenario involving a Flávio victory, she said the currency and rates could enter a “virtuous cycle,” with the market move potentially stronger than the depreciation that could occur under a Lula reelection.
Drawing on market behavior during previous elections in Brazil and other emerging economies, Kiguel estimates that domestic assets could eventually price a 10.5% Selic base rate. Under a Flávio victory scenario, she sees the January 2029 DI futures rate falling by around 2 percentage points. The contract closed Friday at 13.84%.
Under a Lula victory scenario, she estimates the move would be in the opposite direction, with the rate rising by roughly 1 percentage point.
“That result [following a Flávio victory] would look somewhat overdone to us, even if it were consistent with a virtuous cycle and the recent electoral shifts to the right across emerging markets,” Kiguel said.
While the prospect of fiscal adjustment could lower estimates of Brazil’s neutral interest rate — the rate that neither stimulates nor restrains demand — that process would take time, she said. The Brazilian economy would therefore still require high rates for some time, “limiting the extent of the rally over time and leaving it vulnerable to a correction.”
Foreign caution
Other foreign banks are also taking a cautious stance. Société Générale, for example, has stayed out of Brazilian assets for several weeks.
Latin America strategist Brendan McKenna said uncertainty surrounding the election remains unusually high only weeks before the first round.
The recent increase in Bolsa Família, Brazil’s flagship cash-transfer program, which fueled market volatility last week, “is another example of why we have maintained a neutral stance on Brazilian assets ahead of the election,” McKenna said.
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“Brazil has little to no fiscal room for additional spending, and typically, when local assets decouple from broader trends across Latin America, domestic fiscal policy is the reason,” he said. “With both candidates reportedly linked to domestic scandals and another round of fiscal easing ahead of the election, we will remain neutral on Brazil until we have greater clarity on what the economic policy platform will look like after the vote.”
The Lula administration announced a 15% increase in the minimum Bolsa Família payment last week, raising it from R$600 to R$691 beginning Oct. 19.
FX positions
The currency is drawing somewhat greater interest from some banks.
Citi remains overweight the real and holds a long position in the currency as part of a carry-trade basket. J.P. Morgan has exposure to the real through options but maintains a neutral overall bias.
Bank of America is less cautious than some of its foreign peers.
Strategists Ezequiel Aguirre and Lucas Martin said the election has “become the main driver of Brazilian assets” and noted that Lula “has failed to build a comfortable lead.”
With interest rates now looking “too high,” in their view, BofA sees the election as creating additional upside potential for local assets under a scenario that investors interpret as favorable.
BofA trade
Against that backdrop, BofA has recommended buying the January 2037 NTN-F, a fixed-rate Brazilian Treasury bond.
“This trade captures high real rates, a deeper monetary easing cycle than the market is pricing and positive election-related asymmetry,” Aguirre and Martin said.
They added that historical episodes “show that credible prospects for fiscal adjustment can produce a strong bond rally.”
