Amid the significant decline of local assets in recent weeks, some investors have spotted a tactical opportunity to increase their exposure to Brazil. However, the ongoing poor performance of domestic assets has only fueled greater pessimism among market participants, who are growing increasingly impatient with the direction of Brazilian economic policy, particularly in a global context that is becoming increasingly challenging for emerging markets.

President Lula’s remarks Wednesday morning significantly impacted Brazilian financial assets. During an interview with the UOL portal, he addressed concerns about Brazil’s public debt, asserting that it is not growing too rapidly. He dismissed any adjustments to the minimum wage policy and suggested that the real issue isn’t about cutting back but rather assessing “whether you really need to cut back or if you need to increase revenue.” These statements contributed to a rise in the risk premium in the markets.

The exchange rate experienced a sharp decline, closing the session at R$5.5188 per dollar, marking a 1.2% increase. This movement occurred on a day characterized by a general uptick in the dollar and pressures from Treasury yields. In June, the U.S. currency rose by 5.14%, positioning itself for its largest monthly increase in two years.

In the interest rate market, long-term rates faced renewed pressure: Brazil’s interbank benchmark rate, known as CDI, for January 2029 escalated from 11.915% to 12.055%. Meanwhile, Brazil’s benchmark stock index (Ibovespa) managed to buck the negative trend affecting other markets, thanks to gains in exporter stocks, finishing the day up 0.25% at 122,641 points.

“The situation has been more or less stable since the beginning of the year, but reality is starting to set in,” said Drausio Giacomelli, Deutsche Bank’s chief strategist for emerging markets. “The truth is that unsustainable policies eventually lead to collapse. A growth model that relies on increased demand, higher spending, raised taxes, and credit expansion is fundamentally unsustainable in a global environment characterized by higher interest rates and reduced tolerance for fiscal discrepancies,” he explains.

For Mr. Giacomelli, the discussions in April about rising neutral interest rates in developed economies marked a turning point in how the market views Brazil’s fiscal situation. “That was the beginning of the end of complacency towards spending. However, immediately following the April sell-off, all three branches of the Brazilian government indicated their intention to increase spending. Essentially, this was the wrong signal at the wrong time,” he explains.

Mr. Giacomelli criticizes Brazil’s response to its fiscal challenges as inadequate. “We’re attempting a fiscal diet without giving up chocolate, fat, cheese, and wine, relying on shortcuts like Ozempic? That might work short-term, but we could see the exchange rate reach R$6.00,” he warns. As conditions deteriorate, he notes, the market begins to look for historical benchmarks. “It’s all speculative, but history offers some clues. We saw R$5.90 [in 2020]. Adjusting the 2002 exchange rate for inflation, we might see something like R$6.50 or even R$7.00 per dollar. These historical references suggest that the ceiling is not at R$5.50.”

According to a fixed-income trader at a major local bank, “Only a concrete fiscal measure can counteract the negative narrative we’re currently facing, and right now, that would mean implementing a contingency plan of around R$20 billion to meet this year’s fiscal targets. Without such measures, the outlook will remain bleak.”

“In terms of positioning, it’s wise to maintain a light portfolio and navigate through the market’s volatility. We’re essentially in survival mode.” He highlights the recent depreciation of the real and the consistent increase in future interest rates as key factors influencing this strategy.

The perspective shared by Goldman Sachs strategists aligns closely, emphasizing that credibility in fiscal management is crucial, akin to the discipline shown in last week’s decision by the Central Bank’s Monetary Policy Committee (COPOM). For a sustained improvement in the Brazilian exchange rate, they argue, “We need clear articulation and a commitment to a medium-term fiscal and monetary strategy to unlock the true potential of the real’s value [by removing risk premiums].”

Adam Capital, anticipating a continued rise in the dollar globally, maintains a long position on the dollar against the real, forecasting that a stronger U.S. currency remains a focal point in the market. “We also anticipate that the U.S. economy will remain robust, which will sustain the dollar’s ascent against nearly all other currencies,” said Fabio Landi, partner and manager at the firm. He attributes the recent trends in the domestic exchange rate primarily to global influences.

“We see Europe grappling with high inflation yet cutting interest rates; the elections in Mexico raising uncertainties that impact its currency; and a narrow interest rate differential, as U.S. rates remain elevated. Considering these factors, the trend towards a stronger dollar globally is expected to persist,” explains the manager at Adam Capital.

He continues, “Observing the movements, the behavior of the real today [Wednesday] mirrored that of the Mexican peso and the Colombian peso. Given our outlook on a robust American economy and a strong dollar, even with potential interest rate cuts in the U.S., it’s challenging to envision a more favorable scenario for Brazil, whether through carry trade or trade balance considerations. Especially since Brazil’s terms of trade are not at optimal levels,” said Mr. Landi.

On Wednesday, in the late afternoon, the dollar had increased by 1.07% against the Mexican peso and 1.37% against the Colombian peso, signaling a renewed crisis of confidence in Latin America. This trend has been exacerbated since the Mexican presidential elections and was further aggravated by the end of carry trade strategies that previously bolstered these currencies.

Denis Ferrari, a fixed-income manager at Kinea Investimentos, attributes much of Wednesday’s negative market reaction to international factors. “The driving force behind the price movement was a widespread sense of despair among foreign investors regarding emerging markets—Mexico, Colombia, Brazil,” he explained.

In Mr. Ferrari’s assessment, the appetite of global investors for risk in emerging markets is waning, particularly as interest rates in the United States remain above 5%. Against this backdrop, Kinea has decided to close its long position in the Brazilian real.

“The sentiment is extremely negative. We’ve just witnessed a coup in Bolivia following unexpected election results in Mexico, which the market did not expect. In Brazil, the fiscal scenario is somewhat chaotic, with the government showing reluctance to cut spending or boost revenue. For international investors, this represents too much volatility for too little return,” Mr. Ferrari explains. “Previously, foreign investors could profit in Mexico while facing losses in Brazil. Now, they’re incurring losses across the board, prompting a significant reduction in their positions. This was clearly reflected in the market dynamics today [Wednesday],” he adds.

(Maria Fernanda Salinet and Augusto Decker contributed reporting.)