Betting Against Brazil's Real

 | Sep 21, 2011 | 10:00 AM EDT
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A couple of weeks ago, I wrote about selling the supersized Swiss franc. Since then, the currency has plummeted 9.1% and more than 18% since it peaked against the U.S. dollar Aug. 9. With the Swiss National Bank's decision to cap the franc's exchange rate to the euro, Goldman Sachs (GS) economist Jim O'Neill has said that there is a chance that it will fall back to parity with the dollar before the end of the year.

That would be another 10% gain in a short position in the CurrencyShares Swiss Franc Trust (FXF)

So what's my next big currency call? Shorting the Brazilian real through the WisdomTree Dreyfus Brazilian Real (BZF)

First, a quick primer on Brazil: It is bigger than you think it is. You could fit 12 states of Texas into Brazil. Put another way, Brazil is about 90% the size of the U.S., and its population of 193 million is equal to that of the U.K., Germany and Italy combined. Throw in winning bids to host the 2014 FIFA World Cup and the 2016 Olympics and you could understand why, in 2009, former President Lula da Silva attributed Brazil's newfound success to a "higher power."

Frankly, that kind of hubris makes me nervous. It's no surprise that the Brazilian stock market began to lose its legs.

Now, it seems to be Brazil's currency's turn. The real has recently fallen off a cliff, reaching a one-year low against the U.S. dollar. It dropped an eye-popping 11% in September alone, after Brazil's central bank cut interest rates last month. That's quite a switch, considering the real had hit a 12-year high against the greenback just two months ago.

In fact, with the real's sharp drop over the past few weeks, you may think I am late to the party on this call -- but I'm not.

The real's drop could be explained by saying that investors are spooked by eurozone woes. Yes, during times of uncertainty, investors head for the exits and pile into safe haven assets like the U.S. dollar. And, yes, the real is not the only currency to fall through the floor. Since Sept. 1, the South African rand, the Indonesian rupee, and the Polish zloty have also been hit hard.

But I believe the real's weakness is due to more than just general investor jitters.

When I looked at The Economist's Big Mac Index just a few weeks ago, I was shocked to see that, adjusted for GDP, a McDonald's (MCD) Big Mac in Rio de Janeiro costs 149% more than a Big Mac in U.S. By this tongue-in-cheek measure, the Brazilian real was the most overvalued currency in the world.

Until recently, the rising real was a huge boon for U.S. investors. Among the BRIC (Brazil, Russia, India, and China) economies, returns in the Brazilian stock market had trounced those of China and India over the past few years, trailing only bad boy Russia. The dirty little secret was that over 50% of the gains U.S investors enjoyed in the iShares MSCI Brazil Index (EWZ) were due to gains in the real.

Yes, the Brazilian stock market had put on quite a show over the past few years, but its performance had been boosted substantially by the artificial sugar high of a soaring currency.

But this is about more than expensive Big Macs in Brazil. The overvalued real is becoming a huge millstone around Brazil's neck. With Brazilian interest rates at 12%, it's no wonder investors have swarmed Brazilian assets. But soaring foreign investment that has boosted the real has now spilled over into other assets, like real estate. No wonder Brazilians are snapping up condominiums in Miami's South Beach at a fraction of prices in Rio.

That has put Brazilian policymakers in a bind. On one hand, the Brazilian middle class is driving record high retail sales, pushing inflation to a six-year high. On the other, Brazilian industrial production is dropping, and analysts are paring back estimated rates of economic growth. Despite the threat of inflation, Brazil's central bank recently cut interest rates by 50 basis points, in part as an effort to drive away foreign capital with a monetary stick.

I've seen overvaluations like this before. Once a currency hits nosebleed levels, as the British pound sterling did in summer 2007 and the Swiss franc did a few weeks ago, something has to give. From the looks of BZF's chart, the damn appears to have broken.

If you trade currencies for anything more than a few pips here or there, you know that they trend longer than any other asset class, so there's plenty of gas left in this one.

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