We have written how “the tide of yield seeking capital flows will surge” as John Bull can stand many things, but he can’t stand two zero percent. One recipient of John Bull’s dollars (managed by PIMCO)  is the Brazilian bond market, where interest rates exceed 10 percent in one of the strongest currencies in the world.

The flood of dollars is putting excess upward pressure on the Brazilian Real, forcing the central bank to intervene in the foreign exchange market,  effectively printing their own currency to buy surplus dollars.   Bloomberg reports,

“The central bank bought $9.4 billion from Sept. 1 through Sept. 24 in the foreign-exchange market, the most over such a period since the end of 2008, as part of an effort by policy makers from Japan to Colombia to slow the appreciation of their currencies...The central bank has purchased dollars every day since May 7, 2009, swelling its foreign reserves to a record $275 billion, to slow the currency’s advance.”

Brazil’s currency has appreciated 37 percent since the end of 2008 causing a loss of competitiveness and a deterioration in the country’s current account deficit.   This, coupled with the difficulty of mopping up,  or sterilizing, the excess liquidity generated through foreign exchange intervention,  is forcing Brazil’s finance minister to consider capital controls to discourage further inflow of dollars.   According to Bloomberg,

“Mantega, 61, said Sept. 27 that the government is considering implementing a tax on short-term, fixed-income investments as other countries engage in a “currency war” to weaken their exchange rates and bolster exports. Brazil implemented a 2 percent tax in October 2009 on foreign investment in the stock and bond markets.”

The announcement caused yields on Brazil’s 10-year bond to shoot up almost 40 bps this week,  inflicting pain for many foreign investors, who hold large positions in the long-end of yield curve.   According to the central bank, foreigners held around $90 BN of Brazilian local currency bonds at the end of August, equivalent to 10.1 percent of the debt, up from 0.8 percent in 2005.   Brazil’s aversion to hot money and excessive current account deficits is understandable given their painful experience in the 1980’s and early 90’s debt crisis.

So there you have it.   Go no further to understand why Gold is at $1,300 and heading north and the U.S. 10-year bond rate is at 2.5% and heading to 2.0%.  The Brazilian central bank has to put its $275 BN in reserves to work somewhere, and it is only one of many central banks in the same boat Ark.

Brazil is fighting one of the early battles of Bubble 2.0 3.0. And this, before QE2 has left port.  Imagine the flood of liquidity if only a portion of excess U.S. bank reserves are put to work and credit starts to expand!   We fully expect price bubbles to inflate in the emerging markets and the pressure for capital controls to increase.  Stay tuned!

A classic “Cup and Handle” technical formation.