By Rodrigo Campos, Marcela Ayres and Karin Strohecker
NEW YORK/BRASILIA/LONDON, Oct 26 (Reuters) - Brazilian markets faced the prospect of a selloff on Monday with the real sliding after Luiz Inacio Lula da Silva's reelection, which upended investor bets on a right-wing victory and put the president's fiscal plans back under scrutiny.
The real weakened around 12% against the US dollar in spot trading as trading in Brazil got underway and Bovespa stock index futures tumbled nearly 15%, while interest
rate futures rose sharply. The selloff extended to Brazil's international bonds, with longer-dated debt hit hardest and the 2056 maturity down nearly 3 cents.
Markets rallied earlier this month on expectations of a shift to the right after Flavio Bolsonaro, the son of former President Jair Bolsonaro, unexpectedly finished first in the opening round of Brazil's presidential elections.
Stocks closed on Friday almost 7% above their level before the first round, while the real was nearly 5% stronger against the US dollar.
Interest rate futures had also reflected expectations that tighter fiscal policy under Flavio Bolsonaro would allow borrowing costs to decline.
Prediction markets had pointed to a Bolsonaro win, with Kalshi pricing in a more than 75% chance of that outcome on Friday.
"We expect a sharp market reaction on Monday, with aggressive repricing, a selloff in assets and interest rate futures likely to hit their upper limit shortly after the open," said Luis Felipe Vital, head of macro strategy at Warren Investimentos.
Bolsonaro's refusal to concede and his pledge to seek an annulment added to investor uncertainty.
"Important for local financial markets will be how quickly Bolsonaro accepts the result – or at least allows the constitution to run its course," said Chris Turner, strategist at ING in London.
Attention will now turn to Lula's choice of finance minister and what it signals about his fiscal approach.
"The key signal for markets will be the next Lula administration’s commitment to fiscal discipline, starting with the appointment of a new finance minister in coming weeks," said Graham Stock at RBC BlueBay Asset Management.
CHALLENGES AHEAD
Lula faces the challenge of slowing the rise in Brazil's debt while protecting social programmes and investment, with investors looking for signs his gradual fiscal approach can bring borrowing costs down.
"(The) Lula administration will have no choice but to do some fiscal consolidation too, but most investors doubt it will be enough to put debt sustainability back on track," said Thierry Larose, portfolio manager at Vontobel Asset Management.
Without confidence that Lula can deliver, lenders could demand higher interest rates, adding to Brazil's debt burden and making credit more expensive for businesses and households.
"Investors want a clear and credible commitment to fiscal discipline," said Alejo Czerwonko, chief investment officer for emerging markets at UBS Global Wealth Management. "We expect the rally that followed the first round to be largely priced out, and sentiment to stay weak until a clear fiscal plan emerges."
Czerwonko said investors wanted an end to campaign-related spending and a believable path to stabilize public debt. "It also means a working relationship with an opposition-leaning Congress, because no fiscal plan passes without it," he said.
Lula's team aims to produce a budget surplus of about 1.3% of gross domestic product by 2030. That would leave money to cover part of the interest bill, reducing the need for fresh borrowing. But public debt already exceeds 82% of GDP, while pensions and other legally required spending limit where savings can come from.
"Lula's policies have talked about spending cuts, but he has not gone into the details of how that is going to look," said Divya Singaravelu, head of research at Meridian 1305 Capital.
(Reporting by Rodrigo Campos in New York, Marcela Ayres in Brasilia and Karin Strohecker in London; Additional reporting by Paula Arend Laier, Fabricio de Castro, Sruthi Shankar and Johann M Cherian; Editing by Aurora Ellis, Lincoln Feast, Alexander Smith and Hugh Lawson)
