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Market distrust of fiscal policy grows as interest rate futures hit yearly high

Rates surpass 12% after disappointing report, impacting exchange rate and stock market

09/24/2024

Maurício Bernardo — Foto: Rogerio Vieira/Valor
Maurício Bernardo — Foto: Rogerio Vieira/Valor

The market once again voiced concern over the state of government accounts, leading to the third consecutive session of pressure on futures rates, which reached their highest levels of the year and settled above 12%. Investors were disappointed by Friday’s release of the bimonthly revenue and expenditure report, which revealed a reduction in the previously announced R$15 billion spending freeze from July. With the perception of a less stringent fiscal policy, risk premiums surged, impacting future interest rates and the foreign exchange and stock markets.

During Friday’s session, rising risk aversion caused significant market stress, which only deepened on Monday. Brazil’s interbank benchmark rate, known as CDI, for January 2029 surged from 12.31% to 12.475%, hitting a session high of 12.575%. On the foreign exchange front, the FX rate neared R$5.60 per dollar but closed at R$5.5344, up 0.25%, while the benchmark stock index, Ibovespa, dropped 0.38% to 130,568 points.

“The reduction in fiscal efforts, announced earlier, sends a negative signal, especially in light of the growing primary deficit,” says Roberto Secemski, chief economist for Brazil at Barclays. “It suggests the government’s tendency to spend up to the maximum limit allowed by the fiscal framework, despite the pressing need for structural, long-term spending adjustments.”

According to Mr. Secemski, the current skepticism in the domestic market stems less from concerns about compliance with the fiscal framework this year and more from a broader lack of confidence in addressing “underlying vulnerabilities” and the “perception of weak commitment to the effective stabilization of public debt.”

This view aligns with that of Luiz Alberto Basqueira, partner and head of fixed income at Ace Capital, who believes that the primary factor behind the market’s recent downturn is a growing “distrust of fiscal policy.” “The market has been skeptical of fiscal policy for some time, but recent small measures and government announcements have accumulated, reminding investors of the persistent challenges with government accounts,” Mr. Basqueira notes.

He points to the Supreme Court’s authorization of additional extraordinary credits, last week’s income and expenditure report, and the announcement of the gas voucher program, which, while likely to be altered by the government, “has already left a scar.”

“This is all unfolding against a very unfavorable backdrop, with increased market concern over the debt-to-GDP ratio. The market is troubled by two things: the perception that the government is not committed to delivering the surplus needed to stabilize the debt and the fact that while the current target can be met, it would be achieved mainly through revenue-side measures, many of which are ‘one-offs.’ The market views this as a low-quality adjustment,” says Mr. Basqueira.

Compounding the negative fiscal outlook is the onset of a monetary tightening cycle, with the Central Bank’s recent communication taking a notably hawkish tone. “The high inflation projection in the reference scenario signals to the market that the interest rate path in the COPOM’s model—already factoring in a 100-basis-point rise in the Selic rate—will need to be more aggressive,” Mr. Basqueira adds. It’s no surprise, then, that Ace Capital has maintained its “long” positions on rising interest rates across the curve.

Both short- and long-term interest rates have been climbing steadily, reflecting the market’s expectation of a more aggressive tightening cycle. The Focus Bulletin, released on Monday, now projects a Selic policy rate of 11.75% per year at the end of January, while the market is already pricing in a rate of 12.75% by mid-next year.

Despite this surge in interest rates, the Brazilian real has not found support. Although the currency gained on Thursday, it has been heavily penalized in recent sessions due to rising risk perceptions.

“The fiscal issue remains the ‘Gordian knot’—the country’s unsolvable problem,” said Andrei Basilio, head of foreign exchange at XP Treasury. “The government missed a key opportunity to show it is addressing fiscal concerns seriously, not just in the short or medium term, but structurally.”

Mr. Basilio emphasizes that it’s not just the numbers in the report that matter, but the lost opportunity. “The Central Bank is clearly grappling with stronger economic growth, which pressures inflation and leads to rate hikes. We’re also seeing improved tax revenues driven by expansionary fiscal policy. This should have been the time to build a fiscal cushion, not the opposite.”

If there are no further negative surprises on the fiscal front and the government delivers on its medium-term promises, the real remains a solid bet, according to Mr. Basilio. “But right now, there’s a bitter aftertaste due to the bimonthly report, as reflected in the yield curve.”

In this context, Maurício Bernardo, fixed-income manager at Vinland Capital, finds the rise in market premiums “reasonable,” given the disappointment with the income and expenditure report.

He notes that the yield curve was already under pressure due to expectations of a higher Selic rate. Now, concerns about fiscal policy have reignited uncertainty, prompting investors to question whether an even larger rate hike, beyond the anticipated 50 basis points in November, might be necessary.

“The risk premium weighs on the exchange rate and fuels market speculation about whether faster monetary tightening might be required. If more tightening is necessary, why not act sooner? The market is factoring that in,” says Mr. Bernardo. Last week, the digital options market for the next Monetary Policy Committee (COPOM) meeting in November briefly priced in a minority chance of a 75 basis-point hike.

In Mr. Bernardo’s view, the market still has room to price in additional risk premiums on the yield curve, driven by expectations that interest rates may need to rise further or concerns over fiscal risks. “If we don’t see positive developments on the fiscal front or more favorable inflation and activity data, it’s reasonable for the market to continue pricing a premium above 250 bp,” he says, referring to the Selic rate the market currently projects for the end of the tightening cycle.

ASA’s head of multimarket, Filippe Santa Fé, shares a similar perspective, calling the recent behavior in the interest rate market “natural.” “He adds, “I don’t think it’s a matter of positioning or that the movement is exaggerated at this point. Perhaps the speed of the adjustment has attracted attention, but we’re clearly not at any extreme in pricing.”

*Por Gabriel Caldeira, Arthur Cagliari, Victor Rezende — São Paulo

Source: Valor International

https://valorinternational.globo.com/
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Analysis: Central Bank is confident that high interest rates are working

Question mark is whether the fiscal policy will not get in the way


12/15/2022

The Central Bank remains confident that the high interest rates are being transmitted to economic activity and will have the desired effect to lower inflation. Obviously, the question is whether the fiscal policy will not get in the way.

The Central Bank’s Inflation Report released Thursday tries to argue that unlike what many analysts believe, there is economic slack, which is having an effect on prices.

In this study, the Central Bank divides the prices of services into two groups. One includes those that are more inertial, that is, prices that rise because of past inflation. The other includes prices linked to the economic cycle, which rise less when there is economic slack.

The results presented by the Central Bank show that prices of services linked to the cycle are lower and falling at the margin. This would be a sign that, in fact, there is economic slack.

This slack is estimated by the Central Bank at 0.8% for the third quarter of this year. The monetary authority said that this slack tends to grow further because the monetary tightening will be felt more strongly by the economy. At the end of this year, the economic slack will probably be at 1.1% and reach an even higher level at the end of next year, at 1.8%.

The Central Bank has revised its estimate of slack, which was a little higher. But this revision is due to the fact that the GDP was revised, and economic growth was higher than expected. This means lower slack, but nothing changes the qualitative assessment that there is slack.

The Central Bank’s estimate of economic slack is much higher than that estimated by the financial market, which sees the economy operating at total capacity in the third quarter of this year (technically an output gap of 0.1%) and an economic slack of 0.7% at the end of next year.

Some economic analysts have questioned the Central Bank, arguing that there is an analytical flaw. Inertial service inflation depends on different variables than cyclical service inflation. Thus, it would be incorrect to say that there is economic slack just because one is below the other.

Diogo Guillen — Foto: Silvia Zamboni/Valor

Diogo Guillen — Foto: Silvia Zamboni/Valor

Confronted with this question, the Central Bank’s director of economic policy, Diogo Guillen, explained that this part of the report illustrates what a set of models used by the Central Bank, which points to the existence of economic slack, says. In this part, in the most recent data, the inflation of services linked to the cycle is receding.

In the section of the Inflation Report where the Central Bank analyzes short-term inflation, there is also some of the monetary authority’s view on the effect of economic slack on inflation.

The monthly readings came higher than expected, partly due to fresh food inflation. But they were not so high thanks to services. “Services inflation was significantly lower than expected, with emphasis on the more favorable dynamics of its underlying component.”

Mr. Guillen has argued precisely that one should look at inflation to identify the effect of economic slack. In fact, the economic slack is calculated in order to know what is going to happen to inflation.

In short, the Central Bank’s report shows that it sees monetary policy working as expected, confirming a scenario in which inflation falls toward the target. Uncertainty about the next administration’s fiscal policy is one thing that may get in the way.

All the noise surrounding the public accounts since President-elect Luiz Inácio Lula da Silva’s victory in the elections has already started to enter Central Bank’s scenario, albeit incipiently.

The Central Bank’s inflation projections have been somewhat stable in recent months, indicating a price hike of 3.3% in mid-2024, basically in line with the targets. But within this stability, some factors accelerate inflation, while others slow it down. In the end, they cancel each other out.

The inflation report lists factors that, since September, have acted in the direction of raising the inflation projection: the short-term inflation surprise and a lower economic slack than previously estimated.

But some forces reduce the inflation estimate. Among them is the fact that the market expects interest rates to start falling only in August, not in June as previously estimated. There is also the fact that the level of economic uncertainty is higher.

These two facts are linked to fiscal uncertainty, which makes the monetary tightening and financial conditions more severe than expected, pushing the economy into a downward spiral.

*By Alex Ribeiro — Brasília

Source: Valor International

https://valorinternational.globo.com/
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Investors look abroad amid doubts about fiscal policy

Wealth and asset management firms see more interest in foreign assets after election

11/21/2022

Roberto Lee — Foto: Silvia Costanti / Valor

Roberto Lee — Foto: Silvia Costanti / Valor

The market jitters caused by doubts about what Brazil’s fiscal policy will look like as of 2023 left everything cheaper, from stocks to long-term fixed-income bonds to the local currency. But instead of taking advantage of low prices, some investors are moving part of their funds abroad, especially after the runoff vote held on October 30. A novelty is that investors have sought U.S. Treasuries, which are widely seen as safe havens, despite the fat premium offered by similar assets in Brazil.

Avenue, a U.S.-based asset management company, saw the number of account openings grew three times above pre-election averages, while remittance volumes more than doubled, reaching on some days more than five times the average of previous quarters, said Roberto Lee, the platform’s founding partner. He declined to reveal the numbers because of the sale of the business to Itaú, which was agreed earlier this year and still depends on the approval of regulators.

Mr. Lee expected this move to end five or six days after the election, but it is still in place. “It is a phenomenon that doesn’t happen only in Brazil. Investors usually wait for the results [of an election or other event] to decide whether to send 20% or 40% [of their portfolios].”

In his view, this is not a capital flight, but Brazilians figuring out that it is worthwhile having part of the portfolio in hard currency.

What draws attention, however, is the destination of this money – short-term Treasury bonds, the more traditional U.S. fixed-income alternative and an asset almost as liquid as cash, which is now remunerating at a level not seen in the past. “That shows that it’s an alternative for capital protection, safety reserve,” said Mr. Lee. “It makes perfect sense, because it’s a broader market that has the safest securities.”

In this type of remittance, the amounts are larger than those destined for the stock market, he added.

In the last two weeks, after the runoff vote confirmed that Luiz Inácio Lula da Silva will be Brazil’s president again from 2023 on, the interest in sending part of the portfolio abroad gained steam, said Thiago de Castro, a partner and CEO of the wealth management company Tag Investimentos. “Investors think that in this new term he [the president-elect] won’t follow the basics of what was the first Lula administration. They see an angrier Lula focused on social policies, as he has always been, but without the fiscal responsibility seen in the past. They expect him to rule like the first term of [former President] Dilma [Rousseff],” who was picked by Mr. Lula to succeed him 12 years ago.

The view of the firm was already that regardless of who wins, the solution to go over the constitutionally established spending cap would be to tax structures that affect the top of the pyramid, from private family funds to inheritances and dividends. “Regardless of the taxation, because there will be taxes abroad as well, people are more interested in having funds in hard currency abroad,” said Mr. Castro. Investors now keep 20% of their portfolios abroad. Mr. Castro believes that this share will increase.

With about R$11 billion under management, Mr. Castro says that at least 20 clients who had no exposure to international assets started a conversation about that. “It was very reactive,” he said, despite expecting two difficult years for developed economies amid interest rate hikes and the economic slowdown expected in the United States, Europe, and China.

But unlike in Brazil, where investors compare their investments with the interbank deposit rate (CDI) on a monthly basis, Mr. Castro perceives an increase in the remittance of funds with the objective of preserving capital. “They look at how the S&P500 has behaved over the last 20 years. They are prepared to seek returns in more developed markets leaving behind eventual premiums that fixed income gives us in Brazil every cycle like the one we are experiencing.”

B.Side, two movements could be seen, said Antonio Costa, CEO of the wealth team: the expansion of the share abroad by families that had already invested in international markets and a greater interest by those who have not yet taken this step. “After the election, many clients approached us to ask what to do in this regard,” he said. “I think it’s natural when you change the status quo and there are no definitions about the government plan, what the Transition PEC [proposal to amend the Constitution] will look like, and who will be in the economic team.” The executive does not consider, however, such movement as capital flight. The Transition PEC is being proposed by Mr. Lula’s team to finance Brazil’s main social programs.

Mr. Costa’s clients are families with at least R$10 million in assets. According to him, this type of client already has interests abroad, use currency hedging, and holds stocks and other assets. As there are also significant risks out there, with geopolitical tensions, tightened financial conditions in developed countries, and the fear of recession, his clients prefer U.S. Treasuries as well. “Despite the overperformance of the S&P500 in recent days, volatility can still hurt a bit,” said Mr. Costa.

Wealth management firms Alloc and Portofino have also identified increased investor interest in international alternatives.

Two weeks ago, Guide was telling its investors to set up some hedges because the market opened up this opportunity in the first trading sessions after the election. One way to do that was to allocate in IVVB11, the S&P500 ETF traded on B3, said Fernando Siqueira, head of research at Guide. It is a way to capture the appreciation of the U.S. stock market and the depreciation of the real without having to send money abroad.

With the recent devaluation of Brazilian assets, the suggestion has already been revised, because prices in the local market have become attractive again, but some investors prefer to hold the bond that replicates the U.S. stock market index. “As much as our vision is that with Lula’s election the chance is that he will repeat what he did between 2003 and 2010 [in his two previous terms], many people doubt and prefer to stay out [of the stock market],” he said.

This move has not accelerated particularly after the election, according to Mr. Siqueira, but those who were disappointed by the defeat of President Jair Bolsonaro have been inclined to do that.

As for the local stock market, the specialist says he already sees good companies trading at a discount, including WEG, Vale, and Gerdau, and some others more linked to the domestic economy, such as Arezzo, Multiplan, and Totvs.

“There are good-quality companies with high margins, which are good cash generators, are not in debt, and fell 10% to 15%. They are buying opportunities,” said Mr. Siqueira. “Others will suffer a lot to pay [their obligations] because of higher interest rates.”

For those who prefer to bet on the Ibovespa ETF, the specialist said the current level – Brazil’s benchmark stock index is just below 110,000 points – is a good entry point, but that in this case investors must lengthen their investment horizon. “There will be volatility because you don’t know what the new administration is going to do. It could test the limits of the market again.”

By Adriana Cotias — São Paulo

https://valorinternational.globo.com/
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