Brazil runoff hedges pile up as Lula narrows the gap

Brazil runoff hedges have become the trade of the week in São Paulo. With polls showing President Luiz Inácio Lula da Silva narrowing the gap on Flávio Bolsonaro before Sunday's presidential runoff on Oct. 25, investors are trimming positions and buying options to protect gains from one of the strongest rallies in Brazilian assets in nearly two decades, Valor International reported.

What happened

The run-up was dramatic. On the first trading day after the Oct. 4 first round, in which Flávio took 47.03% of valid votes to Lula's 45.16%, the Ibovespa jumped 7.7% and closed above 200,000 points for the first time, Exame reported. The dollar fell 4.12% against the real, its biggest drop since 2018, and long-dated interest-rate futures fell by more than 100 basis points. Valor called it the best week for local assets since 2008.

Some of that has faded. The Ibovespa was trading 2.37% below its record and the January 2029 DI futures rate sat 0.5 percentage point above its Oct. 9 low, according to Valor. Fund managers told the paper they had shifted to bullish options structures so they could stay long while capping losses. "We see this move more as a search for protection in the final stretch of the election than as a fundamental reassessment," said Dev Ashish, who covers Latin America as a senior economist at Société Générale.

A Citi survey of 73 investors, published on Friday, captured the lopsided risk. If Lula is re-elected, 79.5% expect the Ibovespa to fall more than 5% on Monday and 62.5% see the real weakening by more than 5%. If Flávio wins, 49.3% expect stocks to rise more than 5% and 48% see gains of 1% to 5%.

Why it matters

Citi's conclusion was that expectations are asymmetric: the outcome markets prefer is only partly priced, while the potential fall in the other scenario is materially larger, Exame reported. That is the logic behind the Brazil runoff hedges, since the cost of being wrong on the downside is bigger than the reward on the upside.

Fiscal policy is the main worry. Some market participants estimate that spending measures announced late in the campaign could exceed R$300 billion, Valor said. Felipe Tavares, chief economist at Monte Bravo, estimated a fair value of about 174,000 points for the Ibovespa if Lula wins and a roughly 55% chance that a circuit breaker would be triggered on B3 on Monday. Political risk is moving rates elsewhere too, as with the Bank of Russia's hold at 14%.

What's next

Polymarket traders gave Flávio a 80% chance of winning as of 08:21 MSK on Oct. 25. Results are due on Sunday night, and Monday's open will show whether the post-first-round Ibovespa rally resumes or reverses. In interest rates, where hedging through options is harder, investors see the biggest moves either way.

After the vote, attention turns to the central bank's November meeting and to who runs the economy from January. Valor's full survey of fund managers suggests the Brazil runoff hedges will be unwound quickly once the result is clear, in whichever direction it points.