More Tightening Ahead in Brazil

052113The market seems to be in agreement on the likelihood and magnitude of a rate hike from the Brazilian Central Bank tomorrow. What happens next is where the debate lies.

The Brazilian central bank (BCB) announces its decision tomorrow, and the market seems to have converged to our call of a 50 bp hike to 13.25%.  Only a small minority of forecasters now expect a 25 bp hike.  This convergence to a more hawkish decision has followed comments by several central bank officials, including Governor Tombini, Deputy Governor Awazu, and newly appointed Director Tony Volpon.  All of them have signaled the need to be vigilant.  The weekly economist survey by the Brazilian central bank still shows rates ending 2015 at 13.50%.  This is at odds with the futures market, which is pricing a bit more than that – closer to 2 more 50 bp hikes, which would bring rates to 13.75%.

Assuming we do get a 50 bp hike tomorrow, what happens next?  In short, we side with the futures market.  We think the statement will not dash market expectations for another 50 bp in June.  The cost of keeping a hawkish bias is low and, despite the rebound in Brazilian assets, officials must know that sentiment remains fragile, especially going into Fed tightening this year.  However, the argument for a 50 bp hike in June is becoming weaker.

Contrary to our expectations, USD/BRL made a decisive break below the key 3.00 level. We think that this will be an important factor for BCB.  And note that most of the drivers for the rebound in BRL are not likely to be reversed, at least not entirely, in the coming months: (1) The rebound in commodity prices has changed relative risk perception across the producer-importer spectrum, and Brazil was one of the beneficiaries.  Iron ore, for example, which accounts for over 10% of the country’s exports, is up some 25% since the start of the month; (2) The release of the Petrobras audited numbers was a (relative) positive development for sentiment; (3) Lack of negative news from the Finance ministry has kept investors believing that Levy will deliver the basics; and (4) The shift in expectations for a later start to the Fed’s tightening cycle has undermined the dollar’s bid.

At this stage, however, we believe inflation concerns may outweigh the move for currency in the BCB’s reaction function.  For this reason, we still think the chances of a second 50 bp hike in June are better than 50%.  Despite all the hikes and hawkish rhetoric, inflation expectations still haven’t eased.  Looking at the central bank’s survey, IPCA is expected to end the year at 8.25% and end 2016 at 5.60%.  Of course, many of the factors that led to the 2015 spike (regulated prices) will be treated as temporary by the BCB.  Still, the center of the bank’s target range is 4.5%, and such a huge upside miss in a year when the rest of the world is fighting deflation is not something to be ignored.

All in all, fiscal and monetary tightening this year will continue to weigh on growth and, ultimately, asset prices.  While there is a chance for further “catch-up” in Brazilian equities, we believe the Bovespa is unlikely to continuing outperforming. The outlook for the currency remains highly uncertain. We reinforce our view that BRL will continue to weaken in the medium-term, but we recognize that exogenous and endogenous forces have a larger positive factor than we had expected in the short term.