Brazil: Is the BCB on a tightening path?

Market Update

Brazil: Is the BCB on a tightening path?

Having moved lower from 2.05 in December to 1.96 at the time of writing, the BRL remains the best performing major EM currency year-to-date, with a spot return of 4.7% to the USD and a total return of 5.5%. The main moves took place around the beginning of the month, and were driven by two factors.

Firstly, the government eased pressure on the BRL, reducing their verbal commitment to an ultra-weak currency and giving the market scope for building USD/BRL net short positions. Secondly, but not less importantly, the BCB has appeared more complacent towards BRL appreciation, until the double intervention in February, with the Bank selling reverse FX swap contracts when the pair hit the 1.95 mark.

Compared to Q4’12, the novelty resides in the fact that the BCB has returned to an almost neutral position in the FX swap market, signalling a change of stance towards BRL appreciation and apparently setting the boundaries of the new trading range at 1.95-2.00 for now. As the pair continues to hover just above the lower-end of this band, appreciation potential could be exhausted soon. While the BCB may only be trying to smooth moves, regardless of their direction, the government has reiterated that they won’t allow the BRL to rally indefinitely, consolidating our belief that USD/BRL is unlikely to rally much further for now.

In this respect, however, the underlying assumptions remain crucial. The market has been speculating that CPI is rising too fast and authorities will need either the support of a stronger BRL to stem imported inflation, or tighter rates, which would eventually translate into a stronger BRL. The BCB have not officially changed their position on future rates, but started communicating their readiness to ‘adjust monetary policy if needed.’ This is a visible change in communication style that is pushing an increasing number of investors to believe that the Copom is dropping the ‘low rates for long’ policy and prepare to deliver a measured number of Selic hikes. The government has reinforced these expectations by providing statements that the BCB can autonomously decide whether to hike interest rates. Comments came from both Finance Minister Mantega, and President Rousseff, who instructed her economic team to make it clear that the BCB has total autonomy to increase rates, according to local newspaper Folha. For more details see Brazil Headlines in the box.

In conclusion, USD/BRL continues to be supported by hawkish market expectations, but we see greater chances that the pair will stabilize and correct going forward. In the meantime, the DI market has sold off heavily on increasing expectations that rate hikes are imminent. DI futures imply +50bp in 3m, +106bp in 6m and +175bp in 12m. This is a sharp adjustment compared to +25bp and +87bp implied in 6m and 12m, respectively, on February 4. We are under the impression that the adjustment is overstretched as macroeconomic assumptions have not changed substantially over the past few weeks. Therefore, we would expect a correction lower, even if the BCB decided to hike the Selic, as monetary tightening priced in now is too aggressive in our opinion and the BCB is unlikely to normalize rates that quickly. The change in expectations has also helped the PRE DI curve flatten faster than we had envisaged. 2Y/5Y now stand at around 76bp from 90bp on January 19, and vs. our 12m forecast of 40bp. In any case, we think the BCB will not pursue monetary tightening and a strong BRL at the same time. The use of one lever should exclude the other, as long as the rebound in economic activity isn’t consolidating. We continue to expect the Selic rate at 7.25% until Q2 2014 (with risks of earlier resumption of tightening, but not as early/strongly as the market currently implies), while our USD/BRL forecasts remain set at 2.02 in Q1, 2.00 in Q3 and 2.01 in Q4, but we do recognize higher BRL appreciation risks.

Cristian Maggio I Senior Emerging Markets Strategist

Beware ‘Credit Supernova’ Looming Ahead : Gross

“Our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic,” Gross said in his February newsletter.

“When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets,” he added.

Gross advocates investors turn to gold and other commodities for inflation protection and currencies and assets in other countries that don’t have such active central banks and huge debt loads. He favors Australia, Brazil, Canada and Mexico.

We would add Norway too!

Bond Alert

AVWM, LLC., is pleased to announce the following new issue municipal bond alert.


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