Currency Forecast - BRL: Neutral Near-Term, Weakening Long-Term - MAR 2018

Brazil Currency Forecasts
Spot 2018 2019
Last updated: January 5 2018. Source: Bloomberg, BMI
BRL/USD, ave 3.24 3.36 3.51
BRL/EUR, ave 3.90 3.86 4.04
BCB Selic Target Rate, % eop 7.00 6.75 7.75

BMI View : The Brazilian real will likely trade sideways over the coming quarters, as a weakening real yield differential with the US is likely to be offset by near-term commodity price strength and improving activity growth . However , volatile sentiment ahead of the general election will create substantial downside risks.

Short Term Outlook (three-to-six months)

The Brazilian real is likely to trade sideways over the short term. Over the last quarter, the unit weakened slightly more than we anticipated as investor sentiment weakened in light of a delay in pursuing pension reforms ( see 'Policy Uncertainty Coming To The Fore', December 15 2017). Nonetheless, the unit finished the year averaging BRL3.19/USD, in line with our forecast ( see 'BRL: Strength Has Run Its Course', September 28 2017).

Range-Bound Over Short Term
Brazil - Exchange Rate, BRL/USD (Weekly)
Source: Bloomberg, BMI

We have modestly downgraded our forecast average for 2018 to BRL3.36/USD, from BRL3.30/USD, primarily reflecting our downwardly revised interest rate forecasts ( see 'Rate Cuts Not Quite Finished', December 7 2017). Our lower interest rate forecast comes amid our expectations for inflation to trend higher in Brazil and for the US Federal Reserve to enact steady rate hikes in the quarters ahead. This implies that Brazil's real interest rate differential with the US will compress, reducing capital inflows and putting downward pressure on the unit. Brazil's real bond yield spreads with the US have compressed over recent months and will likely narrow further, particularly as a lack of progress on fiscal reforms is increasing risk premiums.

Additionally, Brazil's terms of trade are likely to weaken over the coming quarters. Although we are bearish on oil prices ( see 'Brent: Heading Lower Into 2018', December 1 2017), which will offer some support, we expect prices of iron ore, which has become an important part of Brazil's export basket and is correlated to the real's movements, will slump ( see 'Iron Ore: Downward Trajectory From Here', November 8 2017).

Lower Iron Ore Prices Will Weigh On Real
Brazil - Exchange Rate & Iron Ore Price
Source: Bloomberg, BMI

Nonetheless, downside pressures will be offset over the near term by a weak dollar, Brazil's improving growth outlook and the real's relatively competitive valuation. We have upgraded our forecast for real GDP growth in 2018 to 2.0%, from 1.7% previously, reflecting a stronger and more rapid recovery in the labour market than we anticipated ( see 'Consumption To Drive 2018 Rebound', January 2). An improving regional economy is also bolstering demand for Brazil's value-added exports. Meanwhile, the real's real effective exchange rate remains below its 10-year average, even as decade-low inflation bolsters the unit's purchasing power.

Comparatively Cheap Valuation Could Limit Depreciation
Brazil - Real Effective Exchange Rate
Note: Dotted line denotes 10-year average. Source: BIS, BMI

Long Term Outlook (six-to-24 months)

Over the long term, we maintain our view that the real will likely see spot depreciation against the dollar due to the country's inflation differential with the US. We forecast the unit to average BRL3.51/USD in 2019.

We forecast inflation will average 3.5% in 2018 and 4.2% in 2019. Although below Brazil's historical averages, this will outpace inflation of approximately 2.0% in the US, implying weakening purchasing power. Crucially, higher inflation will not be offset by a higher real GDP growth rate, despite our upgraded outlook. A lack of substantial reforms and political uncertainty ahead of the general election in October will keep investment on the sidelines, limiting growth over the medium-term.

Moreover, the election poses significant risks to policy direction that could weaken Brazil's long-term growth outlook, which we do not believe investors have yet priced in. We believe that the public's deep dissatisfaction with the political elite will create opportunities for outsider candidates with populist agendas to mount competitive campaigns, which will threaten the continuity of reforms pursued under President Michel Temer. A strong pro-reform candidate has yet to emerge, and early opinion polls favour candidates critical of Temer's reforms ( see ' Policy Uncertainty Coming To The Fore ', December 15 2017).

Risk To Outlook

Risks to our view are weighted to the downside and are underpinned by the potential for volatile shifts in investor sentiment as the general election approaches. While markets appear to have priced in an expectation that fiscal reforms will be put on hold in 2018, they do not appear to have accounted for the rising likelihood of a new administration lacking the will or ability to continue Temer's reform efforts.