In last quarter, Fitch had downgraded Brazil, following the S&P's decision in the summer. This is the second major agency to downgrade Brazil to below investment grade. We believe Moody's will follow and also that additional downgrades will take place through the coming three months. These should push USD/BRL to 4.80 by end of H1 2016. The main reasoning behind these downgrades is the lack of resolve to stabilize fiscal dynamics.

President Dilma Rousseff said on Friday that her cash-strapped government could consider tapping into Brazil's sizeable foreign reserves at a given moment, an idea that troubles investors already worried about the country's economic decline.

In an interview with the online news service UOL, Rousseff said she was neither for nor against using Brazil's international reserves, which total about $370 billion.

On the other hand, Brazil is running the highest real interest rate in the world. Furthermore, debt to GDP is amongst the highest across EM.

The combination of high real interest rates, negative growth and rising debt to GDP puts Brazil in similar debt dynamics to those observed in Greece back in 2010. The main difference between Brazil now and Greece in 2010 is that Brazil can monetize.

In other words, unlike Greece, Brazil can print its own currency to service its local debt. This could very well be one of the solutions to improve the fiscal outlook. Higher inflation could reduce as much as a third of the domestic debt market, which is not linked to inflation and has reasonably long-dated tenors.

Short 6M in 1Y time FVAs in USD/BRL: This is a contrarian position that should hold in reasonably well even if we do get the 6% drop in the real in H1. ATM vols in USD/BRL have already turned lower from remarkably overbought levels relieved by soft realized performance in recent weeks (3-4 pts. under) yet forward vols are lagging and are priced 2-2.5 vols above.

The likelihood of spikes in vol cannot be disregarded in the short-term though, and BRL spot would swing wildly indeed that would make selling realized vol (gamma) a distinctly uncomfortable stance to take, but think that 20-handle forward vols will have a hard time realizing by the end of the year when greater clarity would have emerged on Brazilian politics and EM overall would have settled down after initial Fed-related tremors.

Hence our decision to take gamma out of the equation via an FVA short that benefits from implied vols falling short of what forwards price in by end-2016.