UPDATE 2-Temer's arrest piles political pressure on Brazilian markets

Brazilian financial markets tumbled on Thursday as investors feared former President Michel Temer's arrest on graft charges will slow proposed pension reform seen as critical to injecting life into a tepid economic recovery. Temer, who left office at the start of the year, is accused of leading a "criminal organization" that diverted 1.8 billion reais ($472 million) in a scheme related to the construction of a nuclear power complex.

The shock arrest comes a day after the government unveiled a drastically watered down austerity plan for military pensions and pay, and a poll showed President Jair Bolsonaro's popularity has plummeted. At one point on Thursday, the Bovespa stock market fell as much as 3.7 percent for the week, which would have made for its worst week since August. Brazil's 10-year bond yield had its biggest rise since November, jumping more than 20 basis points to 8.93 percent and Brazil's currency had its worst day in two weeks, depreciating more than 1 percent.

Markets clawed back some of these losses as the day progressed. There is no direct link between Temer and the Bolsonaro government or its economic agenda. But pension reform is not going as smoothly as the government would like, and the scandal around Temer and his former aides is an unwelcome distraction.

"Given the level of uncertainty regarding reforms, the market is reacting," said Julio Hegedus Netto, chief economist at consultancy Lopes Filho & Associados. "The market is nervous, and very short-term in its outlook right now." Pension reform remains investors' biggest worry. The 10.4 billion reais in savings from changes to the military pensions and pay was well short of the 93 billion reais the government had originally trumpeted.

This raises questions about how much the government will be forced to compromise with other sectors, diluting its savings target of over 1 trillion reais in a decade and slowing its passage. According to the latest Bank of America Merrill Lynch fund manager survey, 80 percent of those polled said pension reform approval will come in the second half of this year, up from 61 percent previously.

A Citi client poll this week showed a consensus for approval in the third quarter and savings of 500 billion to 750 billion reais. Some 22 percent said it would be approved in the fourth quarter or later — or not at all. (Reporting by Jamie McGeever in Brasilia and Gabriela Mello in Sao Paulo; Editing by Tom Brown and Richard Chang)