• FxWirePro: uphold USD/BRL ratio call spreads as Brazilian Lira reflects broader appetite amid major uptrend

    Source: FxWire Pro - Economic Indicators / 06 Jul 2017 07:18:56   Eastern Standard Time

    In Brazil, reform optimism has not waned and there is increasing risk that Temer may not complete his term. USDBRL should move higher as reform optimism wanes. Economic activity should recover and the rate easing cycle is probably over.

    While commodity prices that are important to Brazil that have been slumping massively in recent times – sugar (-25%), iron ore (-30%), soybean (-10%), and oil (-14%) - have plunged in last few months, so terms of trade are working against the currency at the moment.

    But the resilience of the BRL reflects the broader appetite for carry and local factors. The market is largely pricing in a positive pension reform story and the risks are for weaker FX and higher mid-to-long tenor rates in the case of significant dilution or delay.

    A new round of political uncertainty brought about by corruption charges against President Temer caused BRL to plunge and 1M ATM vols to jump this week. Our Latin economists do not view this as a game changer: despite the additional increase in uncertainty in the scenario of a Supreme Court, they still believe that the likelihood of President Temer remaining in office until the end of 2018 is higher than not at this as he probably has enough votes in the Lower House to block the charges.

    Meanwhile, BRL seems to have 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 JPM's 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.