Brazil has been a sweet spot for currency traders all year. Borrow cheaply elsewhere, park the money in the real, and collect the high interest. The strategy, known as a carry trade, has paid off with the real up about 6% against the dollar.
But October is coming, and so is an election that has some investors packing their bags early.
The carry trade works like this: you borrow in a currency with low interest rates, like the yen, then put that money into a currency with higher rates. Brazil's real interest rates are among the highest anywhere, which made the real a favorite target.
That trade got a jolt this week when a poll showed President Luiz Inacio Lula da Silva leading Flavio Bolsonaro by more than most other surveys had suggested. The real posted its steepest drop among the 31 currencies Bloomberg tracks that day.
VanEck's David Austerweil and Eric Fine have avoided Brazilian local bonds ahead of the vote. Vontobel's Thierry Larose has cut his position in the real, saying the currency is "not pricing in at all any kind of unfavorable development on the political side." Aberdeen's Kieran Curtis trimmed too, explaining it is about "preparing for volatility rather than directly following on from a view on the outcome."
The catch: Lula, a leftist, has roughly a two-in-three chance of winning another term according to betting markets. Investors worry he will not deliver the budget adjustments Brazil needs to stabilize its public finances.
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These fears are not hypothetical. In December 2024, a similar wave of anxiety hit hard. The real fell to an all-time low. Stocks, local debt, and foreign-currency bonds all sold off sharply while traders bought hedges against a possible sovereign default.
This time around, the damage has been quieter but real. The $8.4 billion iShares MSCI Brazil ETF recorded its biggest one-day outflow since 2013. JPMorgan lowered its recommendation on Brazilian stocks, saying it preferred to avoid paying for uncertainty. Local bond yields have jumped, and weekly government debt auctions are drawing uneven demand.
State Street data shows investors hold less protection against real weakness than in previous election periods. That leaves room for further declines if they scramble for hedges before the vote. "Investors are finally warming up to the election risks in Brazil," said strategist Ning Sun.
Brazil's problems go beyond politics. Inflation keeps running hot, and weak public finances add pressure. Ibiuna Investimentos expects short-term interest rates to fall while long-term rates rise, reflecting worries that fiscal strain will keep borrowing costs high. Adam Capital points out that the real yield on government bonds tied to inflation has surpassed 8%, which it deems unsustainable.
The real's strength this year has masked the depth of these problems. A strong currency makes debt dynamics look better than they are.
The race is not settled. Some surveys point to a close-to-even contest, and Flavio's father, former President Jair Bolsonaro, won an earlier election after beating expectations. Larose says even a pleasant market surprise would likely leave the real trailing its interest rate advantage, making it less attractive to hold.
Fidelity International's Philip Fielding has moved to a neutral stance on Brazilian debt. He frames the central question simply: "The Brazilian story hinges on how the market interprets the fiscal constraint. For assets to perform well, its primary balance needs to be positive." The tougher question is whether that will occur absent market pressure, or only following a sell-off.
For investors holding Brazilian assets, the next few weeks come down to one judgment call. You can wait and see if Lula surprises with a market-friendly agenda. Or you can decide the election itself is the risk, and cheap insurance is worth buying now.
Austerweil expects a Lula win would disappoint investors and push them to reprice Brazilian assets. Whether that repricing has already started, or is still ahead, is the bet everyone is making.
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