Political Shake-Up Hits Hedge-Fund Trade As Brazil Markets Swoon

As Brazil's markets rallied, month after month, and global investors kept flooding in, the gains were big enough to overshadow the risks from a presidential election that's still almost a year away.

Then, in just a few hours, that suddenly changed.

The nation's assets have been dragged down by waves of selling since Flavio Bolsonaro — the son of the now-incarcerated former populist leader Jair Bolsonaro — emerged as a contender in next year's race. That dampened local investors' hopes that the right would coalesce around Tarcisio de Freitas, a governor seen in Brazil financial circles as the strongest challenger to President Luiz Inacio Lula da Silva.

Friday saw the worst of the selloff. Bond yields jumped. Stocks tumbled as much as 4.5% in the deepest slide in over four years. And the real slumped over 3%, its biggest decline since US President Donald Trump's April tariffs unleashed havoc around the globe. While assets bounced slightly Monday amid mixed signals from Flavio Bolsonaro on whether he would carry out his bid, they were whipsawed by volatility Tuesday when the senator said his candidacy was "final."

The moves were a stark reminder of the political risks that have been largely ignored as investors stampeded back into developing countries around the world this year.

Brazil has been a major beneficiary, leaving its currency up more than 13% against the dollar even after its recent pullback. That was partially driven by carry traders, who borrow in countries where rates are low and invest in those offering higher yields and have seized on local interest rates pinned at 15% even as central banks in the US and Europe started nudging them lower.

"People were caught by surprise," said Jose Oswaldo Monforte, a portfolio manager at hedge fund Vinland Capital.

"To think that everything would move linearly toward an optimal solution a year in advance seems a bit naive to me," he said. "I can only navigate this well by managing risk and having a safety margin. What I can say is there will be volatility and we need to be prepared."

The shift marks the latest example of politics imperiling what have been strong rallies across Latin America. Earlier this year, Ecuador's bonds sold off when it looked like the socialist challenger posed a significant threat to President Daniel Noboa, who went on to reelection. And Argentina's markets tumbled when President Javier Milei was delivered a setback in a local vote, only to rebound strongly when he defied expectations by prevailing in October's Congressional elections.

In Brazil's case, the broader push into emerging markets was strong enough to shunt aside the worries about rising public debt and deficits under Lula.

While the October 2026 race is still taking shape, in financial circles the attention had largely focused on a potential presidential bid by Freitas, the Sao Paulo governor. He served as infrastructure minister in Bolsonaro's administration, a role that boosted his profile with local and foreign businesses, and as governor oversaw the privatization of the state's water-utility while also taking steps to scale back public spending.

His name had continued to resurface in political and market discussions. At a September event, Luis Stuhlberger, CEO and CIO of Verde Asset Management, said Freitas "has been very vocal" about reducing costs. Stuhlberger warned of an "extremely negative" scenario for Brazilian assets if Lula wins re-election next year.

Eduardo Cohn, a portfolio manager at Heritage Capital Partners, said many local hedge funds had been piling into stocks and betting on lower interest rates — positions he said would gain from a Freitas victory. In recent monthly notes, several Brazilian hedge funds said they were doubling down on bullish bets in local assets.

"Funds were very heavily positioned in this trade, and the tendency now is to protect their performance in this final stretch of the year," Cohn said.

That primed markets for a sharp jolt from a surprising political turn that — for now at least — seems to have derailed the prospect of Freitas' candidacy. Flavio Bolsonaro's announcement suggested the election will be a rematch between Lula and the Bolsonaro family, or a race with a swath of right-wing names instead of a united bid. Both scenarios could potentially bolster Lula's re-election chances.

Freitas, who never confirmed he would leave his post as Sao Paulo governor to vie for the nation's top job, announced late Monday that he supports Flavio Bolsonaro's bid. On Tuesday, Bolsonaro's eldest son reiterated he is committed to the race and said he would only step aside if his father was freed from prison — where he's serving a sentence for seeking to overturn the last election — and was allowed to run for office again.

The shakeup continued to drag on markets Tuesday as traders reassessed the country's outlook. Brazil's real fell as much as 1.1% and interest-rate contracts pushed upward, indicating that traders are anticipating they will remain elevated.

"Markets are still with the idea that a fractured right will boost Lula's odds," said Daniel Balaban, a foreign-exchange broker at XP Inc. in New York. "The reaction today is aligned with that narrative."

Source: Bloomberg