Citi Removes the Real from Carry Trade: What Changes for Investors

Citibank has decided to remove the Brazilian real from its carry trade basket in emerging markets. The long position in the Brazilian currency, held since mid-July, has been closed and replaced by the South African rand. The reason is straightforward: the bank assesses the re-election of Lula in the October elections as likely, and the political scenario is already beginning to weigh on the risk-return equation of Brazilian assets.

This decision is significant because carry trade is one of the main strategies that attract foreign capital to Brazil. When a global bank of this size signals that the premium offered by Brazilian interest rates no longer compensates for political risk, the message to the market is clear: the cycle of caution regarding the country has already begun.

Carry trade is an operation in which the investor borrows money in a currency with low interest rates and invests it in another with high interest rates, pocketing the difference. With the Selic rate still at a high level, Brazil was a natural destination for this type of flow. The Brazilian rate, much higher than those in developed economies, created an interest differential that well compensated for exchange rate risk.

The problem is that carry trade works as long as the receiving currency remains stable or appreciates. The moment the market begins to price in instability, the equation changes. The interest differential needs to be high enough to compensate for a potential depreciation of the exchange rate. And, in Citi's view, the October elections are beginning to upset this balance.

The bank's analysts, led by Dirk Willer, point out that predictive markets assign a 67% probability of victory to Lula, against 27% for Flávio Bolsonaro. A second round is considered practically certain, as no candidate exceeds 50% in first-round polls.

The team expects a moderate risk premium to be incorporated into Brazilian assets in the days leading up to the first round. This premium translates into more volatile exchange rates, a steeper interest rate curve, and wider sovereign credit spreads. For a strategy that relies on exchange rate stability, such as carry trade, this scenario is toxic.

The bank also reported that it will wait to take positions in Interbank Deposit contracts, the DIs, which reflect market expectations for the trajectory of the Selic rate. The idea is to wait for the electoral scenario to clarify before betting on the direction of Brazilian interest rates. This is a typical risk management stance in an election year: reduce exposure and wait for the event to pass.

For investors with a shorter horizon, Citi considers that buying protection via CDS (Credit Default Swap) could be an interesting tactical trade. The CDS is a derivative that acts as insurance against sovereign default. When its spread increases, it means that the market is asking for more to protect against the country's credit risk.

However, the bank warns that any widening of spreads tends to be quickly reversed after the election. This suggests that Citi does not see structural risk for Brazil, but rather a point of volatility. It is the difference between a fundamental problem and a perception problem. Brazil's CDS spread historically behaves this way in electoral cycles: it widens beforehand and narrows afterward.

In 2022, for example, Brazil's five-year CDS exceeded 300 basis points months before the election and retreated in the following months, regardless of the outcome. The pattern tends to repeat itself, according to the bank's analysis.

The removal of the real from Citi's carry trade basket is not, by itself, an event that will crash the exchange rate. But it is a leading indicator. When large global banks reduce exposure to Brazil, other institutional investors tend to follow the same logic. Portfolio flows to the country may decrease in the coming months, putting pressure on the real.

For those with investments linked to the dollar or international exposure, this movement reinforces the thesis of maintaining this position as a hedge. For those concentrated in fixed-rate or inflation-linked income, the message is to be cautious with duration: longer bonds tend to suffer more in periods of electoral uncertainty.

The swap for the South African rand is also symbolic. South Africa has its own fiscal and political problems, but at this specific moment, Citi assesses that the South African risk premium is better priced than the Brazilian one. This means that, on the margin, the global market sees Brazil as relatively riskier than a country with equally complex challenges.

In addition to the electoral factor, Brazil's fiscal context continues to be a variable closely monitored by global investors. The trajectory of public debt, the dynamics of mandatory spending, and the credibility of the fiscal framework are elements that, combined with electoral uncertainty, amplify the perception of risk.

Citi's decision is, at its core, a pragmatic portfolio management approach. The bank is not making an apocalyptic prediction about Brazil. It is saying that, given the current level of uncertainty, there are opportunities with a better risk-return ratio in other emerging markets. For Brazilian investors, the lesson is the same as always in an election year: diversification and currency protection are not luxuries, they are necessities.