This write up is to emphasize BRL’s exposures and keep it safe with optimal hedging vehicles amid intensifying speculation of Brazilian central bank’s rate cuts.

How will monetary policy in Brazil develop next year? It seems clear that the central bank (BCB) will continue to cut key rates. But will it maintain the cautious speed of 25bp per meeting or will it move on to 50bp? There is much to suggest that the speed will pick up.

The rate of inflation has fallen notably over the past few months so that real interest rates stand at over 7%. Inflation expectations are falling too. At the same time, the recession in Brazil is still not overcome. In today’s inflation report the BCB is likely to signal once again that more aggressive monetary policy easing would be appropriate if the situation allows it.

Developments on the financial markets will be decisive in determining whether or not the situation allows these steps or not.

BRL came under pressure after Trump’s election victory but has been able to stand up well since then despite a hawkish Fed. So from that point of view, the situation seems favorable, BRL may be able to withstand a 50bp rate cut without too much damage. We will know for certain on 11th January (or rather 12th as the Brazilian central bank always takes its decisions after a close of trade on the stock markets).

Short USD/BRL gamma via calendar spreads:

Gamma is always a positive value, therefore you add Gamma to the value of the current Delta to estimate the new Delta in a rising market and you subtract Gamma from the current Delta to estimate the new Delta in a falling market.

When you are writing an option, you are short Gamma. Hence, if the underlying market moves in your direction, the Delta will tend towards zero.

Thus, we go long BRL RV via long BRL/COP (Target: 950, Stop: 860). We also see this as a carry efficient way to short COP.

At the same time, the BRL vol curve has mildly inverted in 1M – 3M expiries such that it has become economically viable to sell gamma hedged with vega longs via vega-neutral short 1M vs. long 3M straddle calendar spreads.

Directional investors not given to delta-hedging can consider buying calendar spreads of USD call/BRL put one-touch options instead of straddles. For instance, short 1M vs. long 2M 3.40 strike USD call/BRL put one-touch calendars cost a net premium of 16% on mid (equal notional/leg). Assuming unchanged markets in a month’s time, the 1M 3.40 expires worthless and the 2M 3.40 rolls up to 40%, resulting in an acceptable static carry/payout ratio of 2.5 times.