Asset prices already indicate high chance of 50 basis points reduction in key rate Selic in August
07/10/2023
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Mauricio Oreng — Foto: Silvia Zamboni/Valor
The easing of risk perception in Brazil and the signal from the Central Bank that a cycle of reduction of the benchmark interest rate Selic is about to begin has made it clearer for the market to anticipate a reduction in the degree of interest rate contraction in the coming months. However, monetary policy remains at a very restrictive level, and given the decline in inflation expectations in recent weeks, the possibility of a faster reduction in the key interest rate in the future is gaining ground among market participants.
The monetary stance, i.e., the effective level of monetary tightening in the Brazilian economy, remains at extremely elevated levels, even when considering an increase in the neutral rate of interest — the one that neither stimulates nor contracts the economy. Considering the Selic level of 13.75% and inflation expectations 18 months ahead, the effective level of monetary tightening in the economy remains above 400 basis points over the last 11 months, according to Santander’s calculations.
“Inflation expectations 18 months ahead are declining slightly, which increases the estimate of the ‘real’ Selic. On the other hand, the estimate of the structural interest rate has risen and is around 4.8% in our calculations — a result similar to that of the Central Bank. This leaves the level of monetary policy tightening oscillating between 400 and 500 basis points,” said Mauricio Oreng, head of economic research at Santander. However, he believes that the dynamics of market interest rates suggest that “part of the easing, in a way, is already taking place.”
The market is already starting to price in a lower Selic ahead. “It is the yield curve that has an impact on economic activity, which has a greater impact on the credit market, etc. In this case, we are already seeing an easing, albeit indirectly. Because we are approaching a cycle of cuts, the market understands the conditions of monetary policy and the way the Central Bank reacts, which generates this movement in the curve,” said Mr. Oreng.
According to Santander’s calculations, the market is already working with a tightening level of 240 basis points when observing the monetary policy stance through the behavior of the ex-ante real interest rate, derived from the 360-day interest rate swap and inflation expectations.
And, looking at market prices, in recent weeks there has been an increase in the strength for the Central Bank to start the cycle in a less parsimonious way, with a 50 basis points cut in the Selic in August. At the close of day on Friday, the digital options market indicated a 45% chance of 25 basis points cut in the key interest rate at the next meeting of the Monetary Policy Committee (Copom), against 41% for 50 basis points cut.
“The level of the Selic at 13.75% was consistent with a negative scenario of long-term expectations. Suddenly, the level has halved, with the risk of going even lower. This opens up space for the Central Bank to be a little more aggressive at the beginning of this cycle, precisely to deal with this re-anchoring of expectations. It is as if it were an answer,” said Igor Velecico, chief economist of Genoa Capital, when forecasting a reduction of 0.5 percentage points in interest rates in August and a Selic of 11.75% at the end of the year.
The economist notes that the domestic argument is the most relevant in this sense. “The economy has been slowing down for some time, but agriculture has masked this effect in the aggregate GDP data. Domestic demand is feeling the effect of monetary policy,” he said. Furthermore, about inflation, Mr. Velecico said that with the confirmation of the target at 3%, there has been a “relevant” movement in the Focus survey with the convergence of long expectations to 3.5%. “And that produces, in the BC model, a discrete improvement that can take the projections to 3% or even a little below.”
However, there are some risks to Genoa’s scenario of 50 basis points cut in the Selic in August. To Mr. Velecico, some indicators in the United States have come in higher than expected and signal that the U.S. economy “is not slowing down so quickly and will force the Federal Reserve to raise interest rates one or two more times, or even more. He also noted that the Fed’s policy adjustments have an impact on emerging markets, which creates uncertainty. “That is the main negative element for our forecast.”
For Mr. Velecico, the Copom “cannot be tied to the communiqué or the minutes.” “We live in an emerging market where, in 45 days, the scenario can change a lot. What we saw was a reaction to expectations that few people expected. I don’t see a cut of 50 basis points in August as an act against the communication, since the Central Bank would be responding to an improvement in the scenario that has materialized in the expectations,” said the economist.
Banks such as Safra, Bank of America, and Galapagos Capital also point to a 50 basis points reduction in interest rates in August in their scenarios. And, more recently, Novus Capital has also started to consider this possibility in its base case.
“We changed our scenario after the publication of the Focus survey [last week], which showed a stronger decline in inflation expectations than we had imagined. And we believe that this movement may continue in the coming weeks,” said Tomás Goulart, the chief economist at Novus.
The manager expects Copom to maintain the 50-basis points cut for eight meetings, which would bring the Selic to 11.75% by the end of this year and to 9.75% in 2024. “We have the impression that if it starts with 50 basis points cut, the Central Bank will prefer to maintain the pace because the global environment is not easy. The discussions abroad are about higher interest rates, not lower, and we cannot have a policy that is uncorrelated to the rest of the world for a long time,” he said.
In Mr. Goulart’s view, the real interest rate above the level required for the country to achieve its inflation target is the main justification for starting the cycle of Selic cuts. “We tightened the Selic to bring inflation to the target, the tightening is doing its job and inflation is returning to the target. Now we can work with a lower real interest rate, closer to what the Central Bank considers neutral,” he said.
Mr. Oreng, with Santander, opts for the caution emphasized by the Central Bank in both the communiqué and in the minutes of last month’s Copom meeting. “In terms of how we see the fundamentals, I don’t see the 50 basis points scenario as likely. But, of course, it all depends on the data. I have a lot of confidence about 25 basis points cut in August,” he said.
“The most important variable for the Central Bank’s decision-making is its model, which depends on several variables, such as the Focus inflation expectations. Focus will have a lot of weight, especially in BC’s models, but the horizon continues to be predominantly 2024. Since we are already in the third quarter, the BC’s pocket rule indicates that the year 2025 is already on the radar, but it is not yet the main year on the horizon,” said Mr. Oreng.
In Santander’s baseline scenario, the Selic starts to decline with 25 basis points cut in August; reaches 12.25% by the end of the year; and ends at 10.5% in 2024.
*Por Victor Rezende, Augusto Decker — São Paulo
Source: Valor International