Rio Bravo partner rebukes Treasury push to revisit tax-exempt securities

In his view, the proposal amounts to “an attempt to pin problems that belong to the government on others,” and would do little to solve the Treasury’s real difficulty: placing NTN-B inflation-linked bonds in the market.

Speaking to Intraday, Valor’s financial markets blog, Buccini says that after a strong credit expansion cycle, Brazil is likely headed for a “prolonged digestion” of recent problems. “If the economy does slow down, it could become a critical moment for the credit market. And if the Central Bank has no room to cut rates, it could be the worst of both worlds,” he says. Even so, he stops short of predicting a “credit crunch.” Below are the main excerpts from the interview:

Valor: Is a renewed escalation of the conflict between the U.S. and Iran on your radar?

Evandro Buccini: We saw the attacks last week, but the market reaction wasn’t especially strong this time. Brent crude jumped 8% early in the week, then largely recovered without another sharp swing, even with no ship traffic through the Strait of Hormuz. It’s clearly an issue that worries the market a great deal, and we don’t seem close to a lasting resolution. It will keep driving volatility and uncertainty in prices, and central banks will need to factor it into monetary policy decisions.

Valor: We’ve even seen the correlation between oil prices and market interest rates come back…

Buccini: That’s right. Markets had become somewhat decoupled, partly because we haven’t yet seen the full fallout from higher oil prices. It’s not just about price—it’s also about the supply of oil and refined products. On top of that, countries’ reserves are low, and that’s likely to remain an issue for some time. We’re seeing Japan and Europe raise interest rates in response to inflationary pressure that isn’t being driven by oil alone. In the U.S., though, where large-scale oil and gas production is an advantage, the Fed may be slower to act, especially given its mandate’s focus on core inflation, which buys the central bank a bit more time. The big development at the Fed has been its new chair, Kevin Warsh. His appointment came as something of a surprise, since many expected him to lean more dovish, favoring lower rates. My sense is that nothing will change at the next few meetings, and rates will hold steady.

Valor: Does that point to a scenario of higher long-term interest rates globally and a stronger dollar?

Buccini: On the rates side, yes, that’s the trend—especially with economies, the U.S. in particular, still running strong. Rates are likely to stay higher for longer. On foreign exchange, it’s more complicated. Higher rates usually mean a stronger currency, but every developed economy is moving in the same direction at once. There are also U.S. policies aimed at weakening the dollar through other channels. And the war itself is widening the U.S. fiscal deficit. So, it’s not obvious to me that the dollar strengthens from here. For Brazil, the picture is neither good nor bad. We’re a major oil producer with very high interest rates. Against the dollar, the real could hold roughly where it is, maybe even see some marginal appreciation. The catch is that what actually weighs on the real right now is Brazil itself—our fiscal problems and the coming election.

Valor: Is there still room for further Selic rate cuts?

Buccini: We’re in a very sensitive cycle built on fragile foundations. Everything hinges on the exchange rate and commodity prices. And while the prevailing view is that the economy will slow eventually, there’s no concrete sign of that yet. It’s a fragile cycle that will keep depending heavily on volatile factors, which is far from ideal. There’s still a long stretch before the Monetary Policy Committee’s August meeting, so I can’t say whether there’ll be room for another cut. If the decision were made today—with the exchange rate fairly stable and June’s IPCA reading coming in softer—there might be room for one more cut. But by August, honestly, I couldn’t say.

Valor: We’ve seen considerable volatility in the sovereign bond market…

Buccini: Yes. We’re seeing some opportunities in NTN-Bs, but we’re keeping positions relatively small since there’s no clear sign the volatility will ease. Current levels are attractive, and break-even inflation is quite high, so we do see some opportunities there. That said, there are concerns. Government auctions hadn’t been going well, though the latest one was somewhat better, and there’s still a shortage of buyers for long-dated paper. The real issue: pension funds aren’t buying, and foreign investors aren’t showing up. I prefer intermediate maturities, just past 2030, since they offer more manageable duration for hedging—or choosing not to hedge—against tax-exempt infrastructure debentures.

Valor: The market has pointed to a worsening fiscal outlook to explain this…

Buccini: You have to look at everything that’s happened over the past four or five years. Since the end of the Bolsonaro administration, growth in public spending has been a major concern. And the first half of this year was rough. That’s not entirely surprising, given that we’re in an election year and a spending acceleration was entirely predictable. The problem is that it pressures government bonds and pushes interest rates higher—there’s no getting around that. Gross government debt has climbed roughly 10 percentage points of GDP over this period. That’s extraordinary. And frankly, I have little confidence that will change. There’s talk that some targeted fiscal adjustment could happen even under the current administration after the election, but that’s hard to believe. Economists have long expected the economy to slow, and it never has. But it does look like that could finally materialize over the next few years. If growth slows, that could open room for rate cuts, but it would be a negative from a fiscal standpoint—it’s hard to cut spending when the economy is growing slowly, or even contracting.

Valor: Is the election a concern?

Buccini: The only real way out of this would be a confidence shock, but it doesn’t look like the election will produce a candidate capable of inspiring that kind of confidence. For us, the key will be gauging how the election affects the broader economic outlook. Regardless of who wins, we’re skeptical that a confidence shock materializes.

Valor: We’ve seen a significant widening in spreads on tax-exempt infrastructure debentures. Has the worst passed?

Buccini: I think we’re nearing the bottom of the widening in infrastructure spreads relative to NTN-Bs. The past few months have been very tough, with heavy fund redemptions. But looking at secondary-market activity and funding, we may start to see some spread tightening ahead.

Valor: The Treasury has signaled interest in revisiting tax exemptions on certain securities…

Buccini: That would hurt the tax-exempt securities market. To me, this is an attempt to pin problems that belong to the government on others. Tax-exempt infrastructure debentures do create some competition for government bond issuance, but that’s far from the main problem—I doubt their impact is all that significant. Sure, one or two auctions with very large issuances worth several billion reais could have some effect, but that doesn’t look like the main driver of pressure on NTN-Bs. We’ve already seen five or six formal proposals to change these tax exemptions, and Congress has rejected every one. Nothing stops the government from trying again, but is it really worth the political capital? As it did with CRIs and CRAs, the National Monetary Council could instead change the collateral rules—limiting issuance size, for instance.

Valor: Several major credit events have surfaced in recent months. Is that a concern?

Buccini: Yes. Interest rates are very high and are even catching up with companies that weren’t especially leveraged. No one expected rates to stay at these levels for this long, particularly given that the previous cycle started with rates at 2%. And of course, there are important sector-specific issues at play.

Valor: Such as?

Buccini: Agribusiness, for one. It’s an important, complex sector going through a significant leverage cycle, and it’s also been hit by opportunistic behavior in some judicial restructuring cases that will leave lasting scars on the industry. With Banco do Brasil lending less, or taking a tougher line, capital markets will be far more cautious than before—just as they were making their first serious push to build closer ties with agriculture. We’re also seeing a lot happening in the energy sector, largely because the government has shown little appetite for organizing the industry and has let Congress do as it pleases. It’s a sector that matters a great deal to capital markets, and it’s now facing numerous restructurings.

Valor: And this comes after a boom in the credit market…

Buccini: Particularly among retail investors. Infrastructure matters a lot to them, and we’re now seeing the country’s largest out-of-court debt restructuring, with Raízen. It’s affected a huge number of people. Distributing credit assets to retail investors became much easier, which allowed for broad dispersion that’s now causing headaches. Even a single restructuring is a real challenge for asset managers and changes our day-to-day work. Multiply that across a large, dispersed base of retail investors, and it gets even more complicated—and that dents the sector’s overall appetite for credit. If the economy does slow, it could become a critical moment for the credit market. And if the Central Bank has no room to cut rates, it could be the worst of both worlds. We’re currently at a Selic rate of 14.25%, with the economy still growing. If GDP growth drops below the current 1.5%-to-2% range and rates can’t come down, the outlook could get considerably tougher.

Valor: Is a credit crunch on your radar?