Brazil: Investors seek protection against possible fiscal profligacy due to elections

RIO DE JANEIRO, BRAZIL – Traders in Brazil are rushing into hedges to protect against weakness in the Brazilian real and higher interest rates amid an expected fiscal splurge from October’s presidential election.

Traders flocked to long dollar positions in the futures market and rushed to replace swap rate takers with payers on Tuesday, June 7, after President Jair Bolsonaro announced a plan to cut fuel prices on Monday. That sent the real down more than 2% and long-term rates up more than 20 basis points.

The tax cut plan, which some estimate will reach R$80 billion (US$16 billion), confirms traders’ concern that Bolsonaro will increase public spending to boost his popularity ahead of the October elections.

It also shifted the market’s focus to domestic issues after external factors, such as Federal Reserve policy and supply chain issues, drove risk appetite in recent months.

Bolsonaro said his government would eliminate all federal taxes on gasoline and ethanol through the year and invited states to do the same for diesel and natural gas, saying the Treasury would make up for the lost revenue.

High inflation is one of the biggest obstacles for Bolsonaro in raising his support in election polls.

XP Inc. said in a note that this year’s inflation rate could be reduced by as much as 1.4 percentage points if the fuel tax cut is fully passed on to consumers.

But for traders, concerns that the measure will cause a deterioration in fiscal accounts outweighed any relief the tax cut may offer to inflation in the short term.

Brazil’s Economy Minister Paulo Guedes said on Monday that the revenue compensation to the states would be financed with “extraordinary revenues” not included in the budget.

In addition to increased spending, traders are concerned that the move will lead lawmakers to ask for more money to support the bill.

Short-term swap rates quickly reversed a drop seen at the open, and the Brazilian real led losses among its emerging market peers.

The currency is now contemplating the psychologically important level of R$5 to the dollar, although significant technical support is only at R$5.2 to the dollar, last seen on May 12.

With information from Bloomberg