Political problems in Brazil have damaged BRL’s position as the darling of the Latin world. However we would be wary of chasing MXN gains, given election risk in 2018.
Political risk intensified again in Brazil, with President Temer perilously hanging onto power amid new corruption allegations. Considering the uncertainties associated with another change in power in Brazil, the selloff in local assets has been relatively mild.
The BRL remains vulnerable but it is supported by the stronger fundamentals seen in external accounts and inflation. The CB also has enough firepower for FX intervention to stabilize the BRL, should demand for FX hedge surges in the coming weeks/months.
Still, the political crisis has clearly harmed prospects for fiscal-enhancing reforms and, as a result, for a robust economic recovery. The monetary easing cycle should continue, albeit more tentatively, assuming the USD/BRL does not overshoot towards 3.5, staying around its medium-term equilibrium, close to 3.2-3.3.
Our latest developed market FX views and forecasts
EUR/USD is starting to trade consistently above levels typically associated with short term interest rate spreads. We attribute that to speculation of ECB tapering this summer. We think the ECB will have to provide updates on the PSPP scheme either at its 20 July meeting or more likely its 7 September meeting. We have a baseline view that Bund yields break higher in 3Q17, carrying EUR/$ to 1.15.
In the US, rates and ineffective Trump policy are holding the dollar back. On rates, there is a huge gulf between market pricing of Fed Funds at end 2018 (+40bp) versus Fed Dot Plots (+100bp). The balance of risks to US activity/inflation points to the Fed moving to the market – and not vice versa. This is neutral/negative for USD.
European political risk has ebbed, but Italian elections in 1Q18 may restrain EUR/USD strength – delaying the 1.20 story until 2Q18.
The failure of price pressures to emerge, even in mid-to-late cycle economies, is being welcomed by investors. Risk-free benchmark rates remain near ultra-low levels and may not be seriously challenged until later in the year. For FX markets, a mostly neutral dollar outlook means investors can chase growth or re-rating stories.