Marcela Ayres & Tatiana Bautzer

BRASILIA/SAO PAULO – Analysts and government officials fear that the Brazilian currency’s massive rally could soon end, due to U.S. rate increases and Chinese economic risks. These factors threaten the foundations of Brazil’s top-performing major currency.

The Brazilian real gained more than 18% this year against the U.S. Dollar, which is twice as much as any peer. This was due to aggressive rate increases that drew foreign investment flows away from the Ukraine war.

Brazil’s high interest rates of double-digits may offer an attractive carry trade, but the U.S. Federal Reserve is expected to increase its rate quickly. China’s tightening of controls to combat COVID-19 has also had an impact on the prices of iron ore, soybeans, and oil Brazil exports.

Alvaro Mollica is an emerging market strategist. He stated that there are two major risks to the performance of the real. The Fed could raise rates faster than anticipated and China’s economy would slow down, which could impact commodity prices. Citigroup (NYSE:).

A note from his colleagues at Citi Economics on Thursday flagged “a weaker currency ahead” for Brazil, forecasting a year-end exchange rate of 5.19 reais per dollar – a nearly 10% depreciation from Wednesday’s close.

Although Brazil’s Economy Ministry boasted the increase in foreign investment as well as the benefits of having a stronger currency in fighting inflation, officials are not optimistic that this trend will continue. The right-leaning President Jair Bolsonaro has a mixed record in reforms and privatizing state assets. This initial optimism was huge among investors.

“I don’t see any structural factor unfortunately. The market seems to be influenced by a few factors,” stated an anonymous source who asked for anonymity so that he could give his honest assessment. “The dollar went way down even though it was below the equilibrium level of some institutions… “I believe there is potential for some reversal.”

According to the same official, Brazil’s stock exchange has seen a net of 69 billion Brazilian reais ($14.7billion) in foreign flow this year. This is despite an increase in 11% this year.

A ministry source confirmed that the main drivers for the currency rally were not Brazil’s interest rate but are “external”, and subject to change.

However, not all officials are as skeptical.

Fausto Vieira is the undersecretary for macroeconomic policies at the Economy Ministry. He said that business-friendly regulations are boosting investment areas like sanitation. Private capital has increased from 3 billion to 30% billion reais each year.

It projects that new investments in private capital will reach 360 billion Rias by 2025. The goal is to attract long-term, foreign capital flows, regardless of market effect.

But, this may depend on the outcome of this year’s elections. Bolsonaro is currently led by Luiz Inacio Lula Silva, a leftist ex-President who has promised to roll back many of the economic policies of the incumbent.

Analysts are warning that Bolsonaro or Lula could resort to populist rhetoric in the race for the presidency. Investors may be concerned about fiscal discipline.

According to Jonathan Petersen, Capital Economics economist, Brazil’s risks premiums are now lower, which may reflect “fading concerns about fiscal sustainability” and other political risks.

In a Thursday note to clients, he stated that “if our outlook for fallant commodity prices, and weakening economy growth proves right, these concerns might re-emerge,” anticipating that the exchange rate would be at 5.0 reais per $1 by the end.