Difference between Brazilian and U.S. real interest rates increases again after elections
Thiago Mendez — Foto: Leo Pinheiro/Valor
One barometer of the size of the premium demanded by the market is the spread between Brazil’s long-term real interest rate and the U.S. benchmark real rate. Real interest is the indicator that usually represents the true gain from an investment, since it discounts inflation.
The relative resilience of Brazilian assets to the risk aversion in global markets had been reducing the risk premium of local assets throughout the year until very recently. This trend has begun to reverse. Since early November, investors have started to demand a higher risk premium for domestic assets amid heightened uncertainty regarding the sustainability of the public debt in the long term.
In March, at the peak of the discussions about this year’s budget and with the start of the monetary tightening cycle in the United States, the difference between the rate of NTN-Bs (Brazil’s National Treasury notes) maturing in May 2055 and the 10-year U.S. real interest rate was close to 7 percentage points. Since then, the spread has fallen to 4.07 points on November 3, but is now approaching 5 points again.
“We had a very tight election in Brazil, with discussion about what the country’s fiscal framework will be. There is a vague speech of the future administration about combining fiscal and social responsibility, but there is great uncertainty about what will be done and how. In this context, the Brazilian assets had little risk premium,” said Thiago Mendez, head of fixed-income strategies at Bahia Asset Management. Taking the interest rate market as an example, he recalled that the curve priced Brazil against the world in 2023, and the country was expected to be among the first ones to cut interest rates.
“A little while ago, the market priced a cycle of almost 4 percentage points of Selic drop, which would indicate a rate below 10% [per year], even as the United States and Europe will still raise interest rates next year,” said Mr. Mendez. He points out that the agents got excited with the possibility of an orthodox person to take over the Ministry of Finance, but said that, in face of the signaling of a large volume of spending wanted by the elected administration for next year, the real increase in spending is “very big.”
“The risk premium situation of Brazilian assets, which was low, has completely reversed. Abroad, we saw the pricing of interest rate hikes in the United States decrease. The market started to bet on interest rate cuts there, while in Brazil we saw the opposite. Any priced drop is out of the yield curve,” he said. “At this moment, the market considers more likely that the Central Bank will raise interest rates again in the short term.” In this sense, the firm chose to have few positions in Brazilian assets at the moment.
According to the manager, the strong upward movement of interest rates in the last few days has led Brazilian fixed-income alternatives to once again present a “relevant” premium, which reflects the uncertainty with debt sustainability. “We are navigating an environment of great uncertainty in the short term. Volatility will continue to be high, especially in interest rates. The more expenses, the harder it will be for the Central Bank to start reducing interest rates. Given the premiums, if the world helps and Brazil has a credible fiscal framework, assets may once again have room to behave well, but it is still too early for this. In addition, the new administration has not given any concrete signs that it will move along these lines,” he said.
Since the market jitters seen on November 10, the performance of local assets has been very much tied to Brasília and to information about the Transition PEC – a proposal to amend the Constitution aimed at excluding Brazil’s main social program from the spending cap – and about who will lead the Ministry of Finance in the next administration. The disclosure of an alternative PEC, which provides for R$70 billion in expenses above the cap rather than R$198 billion, gave support to the markets on Monday and helped to reduce the risk premium of Brazilian assets. Yet, the high uncertainty prevails and still generates a demand from investors for a premium.
If the Transition PEC is passed with nearly R$200 billion excluded from the cap, as indicated by the first draft forwarded by the transition team to Congress last week, the primary deficit of 2023 could reach a “dangerous” level for the behavior of country risk measured by five-year CDS contracts, said Marco Antonio Caruso, the chief economist of Banco Original.
The bank compared Brazil’s primary result as a proportion of the GDP with the difference between Brazil’s five-year CDS and the average of other emerging countries from 2007 to 2019. Original excluded two exceptional periods: Luiz Inácio Lula da Silva’s first term in office (2003 to 2006), when the CDS remained high due to market fears about his fiscal policy, but in fact surpluses were produced; and the pandemic, when government spending rose to around 10% of GDP, but the market was “tolerant” because it understood that it was an emergency situation.
“Apart from these two periods, we saw that the higher the surplus, the higher the premium of our CDS against the other emerging economies, and the opposite is also true,” said Mr. Caruso. For him, this was already expected, given that the CDS acts as “insurance” against a debtor – in this case, the federal government. “It reflects, in some way, the possibility of a worsening or improvement in the public accounts,” he said.
According to Original’s calculations, the “magic number” that would trigger an excessive worsening of Brazil’s risk measured by the five-year CDS is close to 1% of GDP. “That is, deficits higher than 1% of GDP, looking at Brazilian history, end up triggering a much worse CDS,” said Mr. Caruso.
Original’s estimate for the primary result in 2023 was close to zero. However, if the Transition PEC is approved with an amount close to R$200 billion, this deficit could be around 1.5% of GDP, he said.
The primary surplus that does not make the Brazilian debt explosive is estimated at 2% of GDP, according to the economist. “If the government starts with a deficit much larger than 1%, it is so far away from the 2% [surplus] that it starts to be politically very difficult. If the government started with a smaller deficit and had a signal that this 2% would be reached, maybe the market would settle down,” said Mr. Caruso. The duration of the waiver (permission to spend above the cap), whether it will be permanent or not, and its size “matter a lot” to the market, the economist said.
Not by chance, as noted by Ian Lima, fixed-income manager at Porto Investimentos, the discussion around the Transition PEC without the participation of the economic group that makes up the transition team generated bad mood among market participants. “The market interprets the PEC as a political proposal, not an economic one. The Ministry of Finance and the Ministry of Planning, which will have to comply with what was determined, did not participate in the discussion about what the budget will be. The pilot is not present and the market tends not to like this kind of behavior,” said Mr. Lima.
When referring to the interest rate market specifically, Mr. Lima notes that the market has interpreted the Central Bank’s next move as an interest rate cut, but points out that since it is not possible to see a sustainable growth scenario or debt stabilization, to the extent that it is still difficult to say what the fiscal policy will be, caution with bets on interest rate cuts predominates.
“From the market jitters of the 10th to now, we understand that this is not the time to simply reduce the positions to zero. We left a mix a little shorter, because the whole curve widened and we are, therefore, with shorter positions,” said the manager from Porto Investimentos.
When looking at the long end of the real yield curve, however, Mr. Lima opts for a more careful tone. “It has a premium. A real interest rate above 6.3% doesn’t seem to make sense in historical terms, but we have a discussion about fiscal imbalance and nothing concrete yet about debt sustainability,” he said.
The head of finance at a large local bank says that among Brazilian assets, implied inflation and long-term interest rates are the assets that are currently trading at a positive premium, while the stock market and the real are still trading at a negative premium. “This means that local stocks and the currency are relatively expensive compared to rates and implied inflation, especially,” this source said on condition of anonymity.
“While the tax discussion has been very bad, nothing concrete has been decided yet, but most of the bad news has been fully incorporated into the inflation market,” the executive said. According to Warren Renaissance data, on Monday the “implied” inflation priced by NTN-B maturing May 2025 was at 7.06%.
“Without the proper fiscal support, not even a politically independent Central Bank can control inflation,” analysts at A.C. Pastore & Associados wrote in a report to clients. For them, only with primary surpluses that allow compliance with the government’s budget constraint will it be possible to preserve macroeconomic stability.
*By Victor Rezende, Anaïs Fernandes — São Paulo
Source: Valor International