FX Weekly Overview (Brazil Issue)

Dollar expected to reflect electoral race, bets on US interest rates, IPCA-15, and AI concerns

The week in review

• During the week, the Brazilian real gave back part of the strong gains recorded in October, amid profit-taking and greater caution by investors regarding the Brazilian electoral dispute.
• The release of polls indicating a technical tie and improved voting intentions for Lula reduced expectations of Flávio Bolsonaro's victory, increasing the risk perception of national assets and pressuring the Brazilian real.
• On the external front, persistent inflation in the US was counterbalanced by more cautious statements from Fed officials, limiting expectations for new interest rate hikes in the short term.

USDBRL Variations | Daily: -0.44% | Weekly: +1.78% | Monthly: -1.96% | Annual: -7.36% | In 12 months: -6.78%
Dollar Index Variations | Daily: -0.24% | Weekly: -0.42% | Monthly: +0.30% | Annual: +3.55% | In 12 months: +3.54%

KEY EVENT: Tight Electoral Race in Brazil

Expected Impact on the USDBRL: Bullish

After the wave of optimism with a possible government change following the first round of elections, the latest voting intention polls indicate a narrowing gap between candidates Flávio Bolsonaro and Lula, reinforcing the perception of a tight second-round race.

• In this context, investors continue to monitor the last week of campaigning and the new electoral polls, which should contribute to adjusting expectations for the outcome of the race.
• On Sunday (18), Senator Flávio Bolsonaro and President Lula are expected to participate in the first second-round presidential debate on TV Band.
• On Monday (19), polls from Atlasintel, BTG Pactual/Nexus, and PoderData/Aya are expected to be released.
• Finally, on Friday (23), the candidates are scheduled to participate in another debate on TV Globo.

Why this mattera: A tight electoral race can reduce predictability about Brazilian economic policies for the next four years, increasing the risk perception of national assets, amplifying volatility, and harming the performance of the Brazilian real.

• In particular, recent reactions from financial market agents reveal a preference for electing a new president, who could be more conservative in fiscal policy.
• Therefore, the lower prospect of government change tends to increase the risk perception of national assets and harm the performance of the Brazilian real.

Latest polls: Despite Flávio maintaining a numerical lead in most polls, recent surveys have indicated a trend of narrowing gap between candidates, reinforcing the perception that the elections are expected to remain tight.

• The Datafolha survey showed that Flávio's voting intentions dropped from 49% to 47%, while Lula's remained at 45%, indicating a technical tie.
• The PoderData/Aya poll indicated that Flávio's valid vote intentions dropped from 51% to 50%, while Lula's increased from 49% to 50%.
• The Quaest survey pointed to a technical tie, with Flávio having 46% of the voting intentions against 44% for Lula, with both candidates increasing their voting intentions by 2 percentage points.

Recent government measures: During the week, the main project approved by the government in the National Congress was the Constitutional Amendment Proposal (PEC) on the end of the 6x1 work shift, which is expected to change working hours in the coming months.

• Additionally, the government announced credit and debt forgiveness measures for individual micro-entrepreneurs (MEIs) and the submission of a PEC to Congress to guarantee free public transport on weekends.
• Possible electoral impacts of these announcements were not captured by the latest voting intention polls, increasing investor expectations for upcoming surveys.

Change in strategy: In recent days, President Lula's campaign changed its communication strategy, focusing on influencers and articulation on social networks and communication apps.

• Furthermore, pro-Lula demonstrations in different cities across the country gave momentum to the president's campaign, which seeks to bring to the polls voters who abstained in the first round.
• This set of factors, combined with the government's latest announcements, tends to favor a recovery for President Lula at the polls, although the tight race scenario persists.

Reduced bets on US interest rate hikes

Expected Impact on the USDBRL: Bearish

On the external front, the currency market is expected to react to the decrease in investor bets on an interest rate hike by the Federal Reserve in its October decision, even after hotter-than-expected US inflation numbers.

Why this matters: The decrease in bets on new interest rate hikes by the Fed in the short term tends to reduce the yield on US Treasury bonds (Treasuries) and harm the attraction of foreign capital to the country, weakening the USD globally.

Strongwr inflation: Last week, inflation numbers in the United States surprised by showing stronger readings than anticipated, suggesting more persistent and widespread price pressures.

• The Consumer Price Index (CPI) accelerated by 0.6% in the month, in line with estimates, driven by rising fuel prices.
• The core CPI, which excludes the more volatile components of food and energy, grew by 0.3%, above the median expectation of 0.2%, driven by increased airline tickets, rents, and technological goods such as computers and monitors impacted by the global semiconductor shortage caused by the expansion of investments in infrastructure related to artificial intelligence.
• The Producer Price Index (PPI) rose by 1.3% in the month, above the expected increase of 0.5%, while its core rose by 0.7%, exceeding the median expectation of 0.3%.

Unchanged bets: However, investors continued to bet on maintaining the interest rate by the Fed in the October decision even after hotter inflation numbers.

• Moreover, the absence of short-term improvement perspectives for maritime navigation in the Middle East is expected to keep oil and derivative prices high and pressure global inflation.
• This apparent contradiction seems mainly due to statements by senior Federal Reserve leaders, New York Fed President John Williams and Fed Vice Chair Philip Jefferson, who argued that there is no urgency to raise US interest rates and that the Fed has time to gather more information before the next rate hike.

Less transparent Warsh communication: It is important to highlight that these apparent contradictions are a reflection of changes implemented by Federal Reserve Chairman Kevin Warsh, which made the central bank's communication more concise, generic, and less informative.

• For example, Warsh's statements during the press conference for the September 16 rate decision were interpreted as a clear suggestion that the Fed was beginning a firm cycle of rate hikes.
• However, the minutes of that decision showed that, although the decision to raise rates by 0.25 percentage points was unanimous, there were disagreements about the reasons for this increase (and its implications).
• According to the minutes, "many participants" supported raising rates to reduce the risks of a new inflationary acceleration, while "a number of participants" argued that this increase was necessary due to their inflation estimates and the need to keep inflation expectations anchored.
• In other words, for most, the rate hike was a preventive risk management exercise, while only a smaller portion understood that rates were too low to recover price stabilization.
• This explanation differs significantly from the reasons stated by Warsh during the press conference, which misrepresented the Federal Open Market Committee's (FOMC) stance.

Vocal resistance: Due to this generic and concise communication style and Warsh's refusal to analyze and discuss the American economic outlook, other Federal Reserve members intensified their participation in events, lectures, and interviews.

• Since the September 16 rate decision, there have been more than 40 public statements from other FOMC members seeking to provide greater clarity on the trajectory of US interest rates.
• This increases the importance of speeches by authorities like Williams and Jefferson, who end up taking on the role of guiding monetary policy abandoned by Warsh.

Inflation Data in Brazil

Expected Impact on the USDBRL: Bearish

Domestically, investors are expected to monitor the National Consumer Price Index 15 (IPCA-15), aiming to calibrate their expectations for the inflation trajectory and economic policy in the country.

• The median investor estimate points to a 0.4% increase in October, which would raise the 12-month accumulated inflation from 4.47% to 4.6%, above the target tolerance ceiling.

Why this matters: A stronger inflation reading tends to strengthen investor bets for an interruption in the basic interest rate (Selic) cut cycle, increasing the yields of national public bonds and favoring the attraction of external capital, which would strengthen the Brazilian real.

Latest data: The latest reading of the Broad National Consumer Price Index (IPCA) indicated stronger-than-expected inflation, reinforcing bets on an interruption in the interest rate cut cycle.

• In September, the IPCA measured a 0.70% rise in the month, above the 0.53% price expectations, favored by the end of the Itaipu Bonus.
• The core indicator, which excludes volatile goods like food and energy, rose from 0.12% to 0.42%, reinforcing the reading of widespread inflationary pressures.

Concerns About Sustainability of AI Investments

Expected Impact on the USDBRL: Bearish

Finally, the currency market may reflect heightened investor concerns about the profitability of investments related to artificial intelligence (AI) technologies, which led to sharp losses for the sector's stocks last week.

Why this matters: On one hand, concerns about the profitability of AI companies might generate greater global risk aversion, which tends to favor the performance of assets considered safe havens during stress and uncertainty, such as the dollar.

• On the other hand, these concerns may encourage greater portfolio diversification among investors, who may redirect part of their portfolio to riskier assets, such as currencies from emerging economies.

Fears of an AI "bubble": Last week, investors expressed concerns that the demand for artificial intelligence may not grow as rapidly as necessary to make the intense sector investment expansion profitable, potentially rendering the recent expansion a "bubble."

• In recent years, financial market operators bet heavily on shares and debt securities of AI technology providers and companies supplying essential infrastructure and inputs, such as chips, semiconductors, data centers, and electricity.
• These bets were based on expectations of intense growth in demand for these technologies, believing they would result in significant productivity gains across multiple sectors.
• However, questioning this expectation of intense demand growth, coupled with growing Chinese competition in both infrastructure and input production as well as cheaper AI models, led investors to question the sustainability of initial bets and to divest from positions in more leveraged or poorly positioned companies.

Portfolio diversification: In theory, these concerns about excessive investment by technology companies should result in a risk-averse scenario and a search for safe assets, which typically strengthens the dollar globally.

• However, there was observed a movement of diversification in investments both within the US and internationally.
• The biggest winners from this movement were US debt securities (Treasuries), likely reflecting the search for more predictable fixed-income alternatives, and currencies of advanced economies such as the Swiss franc, euro, and British pound.
• This resulted in a weakening of the US dollar and also benefited the performance of emerging market currencies.
• Therefore, if these concerns extend into this week, they may end up benefiting the real's performance.

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