Higher external risk explains much of this year’s tightening. In Brazil, however, market interest rates also reflect worsening fiscal concerns and rising public debt, which have pushed investors to demand higher risk premiums.

The Financial Conditions Index, or FCI, compiled by Tendências Consultoria using the Central Bank’s model as a reference, has remained in contractionary territory since March, when local and global markets deteriorated sharply following the outbreak of the conflict involving the United States, Iran and Israel.

The index reached 1.23 point at the end of March and has since become more volatile, while remaining in restrictive territory.

The indicator combines price components, including commodity indexes, oil prices and the exchange rate, with market variables such as Brazilian and international stock indexes. It also incorporates risk measures including credit default swap (CDS) movements, volatility indexes and domestic and international interest rates, which carry the greatest weight.

A negative reading signals expansionary financial conditions that support economic activity. A reading above zero, as at present, points to tighter conditions and a less favorable environment for growth.

In practice, the sharp rise in long-term global interest rates has offset improvements in domestic factors that could otherwise ease financial conditions.

The surge in U.S. Treasury yields has prevented a stronger decline in Brazil’s long-term rates, even as the Selic falls and the stock market gains on expectations of a close election between Luiz Inácio Lula da Silva of the Workers’ Party (PT) and Flávio Bolsonaro of the Liberal Party (PL).

“Interest rates abroad are the main source of tightening, followed by oil and, to some extent, currency movements, with the dollar gaining a little more traction,” said Alessandra Ribeiro, partner and director of macroeconomics and sector analysis at Tendências. “But overall, interest rates account for much of the index’s movement, which has come under greater pressure again after a very volatile year.”

Ribeiro said the FCI is at its highest levels since April, showing that financial conditions have been tight for much of the year.

“And the level is not low. We are now seeing the effects on economic activity, with models showing that financial conditions begin to affect the economy after one quarter and that the impact lasts for as long as four quarters. In other words, this will affect activity,” she said.

Growth outlook

Tendências says market performance “only reinforces the scenario of a further slowdown in activity in the second half.”

The consultancy expects gross domestic product to grow by an average of just 0.1% in the second half of this year, leaving a carryover of only 0.3% for 2027.

Tendências forecasts GDP growth of 1.8% this year and just 1% in 2027, underscoring its view that the economy will lose momentum as domestic interest rates remain under pressure.

“If we look at local assets, interest rates are pushing financial conditions toward tightening, while other markets have contributed more positively,” Ribeiro said, referring to CDS and capital markets, which have helped limit the overall tightening.

Diverging signals

Daycoval chief economist, Rafael Cardoso, also sees domestic interest rates as a source of financial tightening, although the bank’s own FCI currently points to expansionary conditions.

One of the main differences from the Central Bank framework involves higher oil prices. Daycoval treats them as a source of financial easing because Brazil is an oil exporter.

“Some components, such as capital markets, the local exchange rate and the performance of emerging-market currencies, end up pushing the index into expansionary territory. But high domestic interest rates and credit delinquency are two factors pointing to very contractionary financial conditions,” Cardoso said.

Although Daycoval’s FCI currently signals expansion, Cardoso said the index is only one input in the bank’s GDP forecasts.

“We know that all indicators have their problems, and the FCI does not capture the duration of monetary tightening,” he said. “It may show a reading close to neutral, or slightly expansionary, but a prolonged period of tight conditions can produce weaker activity than expected.”

Cardoso said that appears to be the case now.

“An FCI close to neutral should point to GDP growth near its potential rate of 2%, but we forecast growth of 1.2% in 2027. Once we move away from the indicator itself, GDP appears likely to perform more weakly than current financial conditions would suggest,” he said.

Fiscal pressure

Vivest chief economist, André Lóes, takes a similar view, saying financial conditions are severely strained in fixed income, though less so in the foreign-exchange market.

“If public-debt holders receive bad news after the election about fiscal proposals, conditions will deteriorate because the yield curve will not come down and there is also a chance the exchange rate could weaken,” he said.

Lóes said investors naturally focus on the direction of monetary and fiscal policy, but private-sector decisions also create an underlying trend that feeds into financial conditions.

“They end up being extremely important. Ultimately, when we reach a situation in which people are worried, the impact of economic policy itself starts to become limited. In other words, fiscal expansion does not help if people respond by consuming less,” he said.

Financial conditions are therefore becoming increasingly important in assessing what comes next for Brazil, Lóes said.

“And because the major imbalance is fiscal, fiscal adjustment becomes very important. Otherwise, it will not be possible to untie the knot in financial conditions,” he said.

“We do not have a balance-of-payments problem, and we managed to bring inflation down to civilized levels, although the sacrifice ratio was very high precisely because of the other imbalances,” Lóes said.

“We have three problems today: fiscal, fiscal and fiscal. If we start addressing that, we can move beyond the very short-term issues and complete the work we began 30 years ago: stabilizing the Brazilian economy and focusing on productivity growth.”

*By Gabriel Roca and Victor Rezende, Valor — São Paulo

Source: Valor International

https://valorinternational.globo.com/