Narrowing gap between Brazilian and U.S. interest rates should make real more dependent on fundamentals and foreign markets
Carlos Calabresi — Foto: Claudio Belli/Valor
The bet on currencies that benefited from high-interest rates in the year’s first half was triumphant, especially for Latin American currencies such as the real. The start of interest rate reduction cycles in the region, however, threatens to change financial agents’ strategy, which could end the boom period in the exchange markets of these countries. In Brazil, with the first cut in the Selic policy rate having already taken place, the economy’s fundamentals, especially in the fiscal realm and the external scenario, are likely to play an increasingly important role in the performance of the Brazilian real.
Uncertainty regarding the performance of the domestic exchange rate stems from the start of a process to reduce carry. Carry trade means borrowing money in one country, investing in another with higher interest rates, and earning on the difference between the rates
While there is an ongoing monetary easing cycle in Brazil and Chile, in developed countries, particularly the United States, the market is still uncertain about the end of the monetary tightening process. In other words, while the Selic is starting to decline in Brazil, U.S. rates could still go up.
In addition, the recent upward pressure on Treasuries has been reflected in even lower interest rate differentials, resulting in a global dollar appreciation.
“It’s not just the carry trade what explains a currency’s performance. There are fundamental factors, such as trade and financial flows and the evolution of public debt,” explained Carlos Calabresi, chief investment officer (CIO) at Garde Asset. “The real’s carry buffer is now losing some of its size, even though [the Brazilian currency’s carry] remains among the most attractive.”
In Mr. Calabresi’s calculations, the interest rate differential between Brazil and the United States fell from 11.5% at the beginning of the year to around 4.5% when considering the spread between the pre-fixed rate and the one-year exchange coupon. “This accelerated reduction occurred because, at the same time as we had prospects of an interest rate cut here, there were expectations of a rise in U.S. interest rates. The two rates, therefore, moved in opposite directions, narrowing the spread,” he said.
But the interest rate level alone is not enough to make the carry-trade strategy attractive. According to Mr. Calabresi, in this type of investment, the investor will be positioned according not only to the interest rate differential but also to the movement of the currency. “If the volatility of the currency being carried is very high, the Sharpe ratio [which assesses the return and risk of an investment] can get worse.”
The one-month implied real volatility was around 20% (considered high by Brazilian currency standards) at the beginning of this year, while more recently, it was around 14%, explained Marco Maciel, chief economist at Banco Fibra. For him, the trend is for the exchange rate to move away from the period of lower volatility seen in recent months, although this will happen gradually.
“I don’t believe that, at first, volatility will return to around 20%, but it should be somewhere between 16% and 18%,” said Mr. Maciel. “Towards the end of the year, it will depend on fiscal execution. If [Minister of Finance Fernando] Haddad delivers a deficit closer to 1% of GDP, without controlling spending, we could see volatility get closer to 20%.”
The same doubts regarding the execution of the fiscal plan are mentioned by Santander senior economist Jankiel Santos as a weight on the fundamentals for an additional appreciation of the real in the second half of the year. “Since the beginning of the year, we’ve seen an improvement, with a reduction in the risk premium. But there are still questions about the public debt, especially on the revenue generation side, which is what is needed to make the fiscal rules draft stand up.”
In addition, the Santander economist said that the non-unanimous decision by the Monetary Policy Committee (Copom) to cut the Selic rate by 50 basis points to 13.25% per year at its last meeting leaves investors with a question mark over a possible acceleration in the Selic rate cuts ahead. “Logically, after this split, the market is in doubt as to whether the interest rate differential could close [decrease] much faster than projected and, therefore, make the currency less attractive.”
The difference in the profile of the governments, the fundamentals, and the very composition of the Central Bank makes it difficult to find a pattern in the performance of the real at times of monetary policy easing. For example, from June 2011 to October 2012, when the Selic rate went from 12.5% to 7.25%, the dollar appreciated against the real by 30%, while from July 2016 to March 2018, with the basic rate falling from 14.25% to 6.5%, the American currency appreciated by 0.7%.
This difference makes it clear that carry trade alone does not tell the whole story of a currency’s performance. That’s why Roberto Motta, macro analyst at Genial Investimentos, emphasizes the importance of observing the economy’s fundamentals. “During the period of falling interest rates from 2016 to 2018, we had a policy of fiscal contraction due to the spending ceiling that had an effect. It’s no wonder the Selic rate came in at 6.5%, and the National Treasury even issued 2050 bonds at IPCA+3%. Today it’s at 5.5%,” he said. “It was a sign that Brazil was getting serious and was taking care of its public accounts.”
Mr. Motta points out that the scenario today is different. “We have a very expansionary fiscal framework, with chances of increasing real spending by around 6%. If we compare, the fundamentals now look worse than they did during the period when Ilan [Goldfajn] was in charge of the Central Bank, with an orthodox policy, and with Michel Temer as president, with a series of economic reforms,” he said.
Domestic factors aside, there are also possible unfavorable winds from abroad that could affect the Brazilian currency. Yields on U.S. Treasury bonds, especially the long-term ones, soared in August amid large bond auctions and the perceived strength of the U.S. economy.
In addition, the Federal Reserve (Fed) has not set the end of the monetary tightening cycle, and there are bets among agents about further hikes in U.S. interest rates. Not surprisingly, the commercial dollar has already risen 5.34% against the real this month. In contrast, foreign investors’ bets on the dollar against the real on the derivatives markets are close to historic highs, at over $50 billion.
“If the Fed decides to raise interest rates even more, we’ll see this differential narrow even faster. Because there’s no sign that the Central Bank here will stop if the United States tightens its policy further,” said Santander’s Jankiel Santos.
*Por Arthur Cagliari — São Paulo
Source: Valor International