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By Asher Levine and Walter Brandimarte
SAO PAULO/RIO DE JANEIRO, Oct 27 (Reuters) - Brazilian financial markets plunged on Monday, with stocks on track for their worst day in more than three years, as the Sunday re-election of President Dilma Rousseff dashed investor hopes of meaningful policy change over the next four years.
Market sentiment going forward will likely depend on whether or not the leftist president signals policy tweaks to boost Brazil's flagging economy, as hinted in a conciliatory first speech she gave after defeating pro-business challenger Aecio Neves on Sunday.
After the most divisive campaign since Brazil returned to democracy three decades ago, Rousseff won 51.6 percent of votes in a runoff against Neves, who won 48.4 percent support.
"Brazil disappointed investors by returning incumbent Dilma Rousseff to the presidential office," Schroders said in a note to clients. "Hopes for reform to address Brazil's structural economic problems have been dimmed, if not dashed."
The Bovespa index lost as much as 6.2 percent in early trade. The index later trimmed losses to about 5.0 percent but remained on track to post its worst single-day performance since the downgrade of the U.S. sovereign rating in August 2008. The real lost about 2.5 percent at 2.52 to the U.S. dollar.
The tight and fast-changing election campaign had sent Brazil's financial markets on a wild ride with big gains whenever Rousseff lost ground in polls and drops whenever her odds looked stronger.
Rousseff's economic policies have been roundly criticized by investors for tipping Brazil into a recession while damaging state-run companies such as oil producer Petroleo Brasileiro SA , known as Petrobras, and lender Banco do Brasil SA along the way.
Preferred shares of Petrobras fell as much as 15.6 percent at the open, while shares of Brazilian sugar and ethanol company Cosan SA dropped over 6.0 percent.
Petrobras' share price has suffered under Rousseff's government due to a policy that holds down domestic fuel prices in order to help relieve inflation. Sugar and ethanol companies like Cosan have also suffered from that policy because it makes gasoline, a direct competitor to ethanol, cheaper.
Shares of Banco do Brasil fell about 8.0 percent. The bank has seen pressure from Rousseff's government to lower lending spreads in order to juice consumption in a sputtering economy.
Long-dated contracts for interest-rate futures also sold off, driving yields on Jan. 2023 futures 62 basis points (bps) higher. Those yields had fallen sharply recently on bets that mainstream fiscal and monetary policy in a Neves' government would make room for lower interest rates in the future.
Brazil's debt insurance costs also rose in the credit default swaps (CDS) market. Data from Markit showed that five-year CDS were up 10 basis points versus the closing level on Friday to 172 bps.
The real has seen downward pressure due to a stronger U.S. dollar globally, though the local currency has been supported by a central bank swap program in what many traders see as a managed trading band.
"The central bank is likely going to increase intervention to avoid what they likely see as overshooting of the real," wrote Citi analyst Dirk Willer.
Any staunching of the losses in future sessions will most likely come on bargain-hunting and signals of more market-friendly policies and cabinet appointments from the Rousseff administration, analysts said.
"The current path is not sustainable without a big adjustment of the policy mix, but in the short run, as long as markets are willing to finance Brazil, this stagflationary scenario could continue for a few more quarters," said Arthur Carvalho, an economist with Morgan Stanley.
"Unfortunately, we also believe that if the administration avoids the hard choices, sovereign downgrades will arrive at some point over the next 18 months, creating a new set of challenges for Brazil," he added. (Editing by W Simon)