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Fiscal risk pushes real market interest rates close to 7%

Medium-term NTN-B rates surpass 6.7% amid uncertainty and Selic tightening cycle

10/09/2024

Luciano Rais — Foto: Gabriel Reis/Valor
Luciano Rais — Photo: Gabriel Reis/Valor

Growing distrust in fiscal policy, combined with the beginning of the monetary tightening cycle, has led to a sharp rise in real market interest rates, reflected in B-Series National Treasury Notes (NTN-Bs)—Brazil’s inflation-indexed bonds—which are now nearing the psychological 7% mark for some maturities. At Tuesday’s (8) weekly National Treasury auction, three-year bond (May 2027) rates hit 6.709%, raising concerns about the government’s increasing financing costs and worsening debt structure.

The recent spike in real market interest rates mirrors stress levels last seen in early 2016 during Dilma Rousseff’s administration.

“Brazil has experienced fiscal distortions and some uncertainty around the Central Bank, but the latter is being addressed,” said Luciano Rais, head of fixed income at Santander Asset Management. However, he warned that the fiscal risks continue to rise. “The current agenda is more focused on boosting revenue rather than cutting spending,” he added.

“The market is mainly suspicious of the structural side. While the deficit is a key concern, it’s being tackled with temporary revenue sources, whereas spending increases appear permanent,” Mr. Rais continued. He also noted that despite restrictive interest rates, economic growth remains strong, which is a concern for the Central Bank as it resumes its tightening cycle.

“The Central Bank’s rate hikes are impacting NTN-B and fixed-rate bond yields. Although longer-term NTN-Bs offer attractive yields, these higher rates don’t seem unjustified. Expected real interest rates will need to rise further,” Mr. Rais explained.

Ronaldo Patah, Brazil strategist at UBS Global Wealth Management, agreed that fiscal uncertainty and the recent monetary tightening have fueled the surge in NTN-B rates. He pointed out that while U.S. Treasury movements have been more restrained—with the real U.S. 10-year rate rising only slightly from 1.74% at the beginning of the year to 1.77% now—the Brazilian 10-year NTN-B rate has soared from 5.4% to 6.5%.

Mr. Patah added that even if the government meets its primary fiscal target for this year, lingering doubts over whether it can achieve a zero deficit next year are contributing to a roughly 100-basis-point increase in real interest rates as risk premiums become embedded in bond prices.

“Without new measures and relying on non-recurring revenues like this year, the expected deficit for 2024 is 0.8% of GDP—well short of the zero target,” warns Mr. Patah, noting the possibility that the government may need to revise its fiscal framework targets. Such a revision could worsen the perception among financial agents, potentially driving real interest rates even higher.

Mr. Patah points to two negative signals on the fiscal front: the government’s push to extend the gas allowance and its proposal to exempt individuals earning up to R$5,000 a month from paying income tax. However, he acknowledges that Moody’s upgrade of Brazil’s sovereign rating, with a positive outlook, might encourage the government to pursue fiscal balance to reclaim its investment-grade status.

Amid these challenges, Luiz Alberto Basqueira, partner and head of fixed income at Ace Capital, sees a negative bias in medium- and long-term real interest rates. His concerns center on Brazil’s public debt trajectory and the recent deterioration in its structure. “We don’t like the level of nominal interest or real rates, particularly in the medium and long term. This is a bias, and we are reducing our exposure to these parts of the curve,” he explains.

Mr. Basqueira also highlights potential external pressures on rates. He suggests that the U.S. Federal Reserve, which has started its monetary easing at a pace of 50 basis points, may not be able to deliver the number of rate cuts the market anticipates. Additionally, with Donald Trump remaining a frontrunner in the U.S. presidential race, Treasury yields could face upward pressure, which would likely spill over into the Brazilian market.

According to Mr. Basqueira, Ace Capital’s strongest conviction in the interest rate market comes from a more pessimistic outlook on inflation. “Beyond structural factors like strong economic activity, a tight labor market, exchange rate fluctuations, and unanchored inflation expectations, we see heightened risks linked to climate issues such as heat and drought. We are particularly pessimistic about food inflation, which we expect to reach 8% this year and 7% next year—well above market projections,” says Mr. Basqueira, adding that he favors long positions (betting on the rise) in short-term “implicit” inflation.

Mr. Basqueira also highlights that competition for funds with the credit market is another factor pressuring medium- and long-term real interest rates. “The demand for hedging from credit funds has contributed to the upward pressure on the real interest rate curve,” he explains.

Moreover, the substantial issuance of incentivized bonds has negatively impacted government bonds. “In addition to the competition, the government misses out on revenue due to the tax exemption for these bonds. They undeniably divert resources that could help finance public debt,” he notes.

As of last month, NTN-B issuances made up just over 10% of the total for the year, as the National Treasury has chosen to focus on selling post-fixed Financial Treasury Bills (LFTs), which are tied to the Selic, Brazil’s benchmark interest rate. This shift has raised concerns among market participants about the composition of the public debt.

“If the government believes that current interest rates are too high and expects them to fall, it makes sense to shorten the debt by selling LFTs, which are indexed to the Selic rate. In a rate-cutting cycle, the cost of the debt would drop quickly. However, if the debt is shortened and the government fails to regain fiscal credibility, the debt structure becomes more vulnerable,” warns Mansueto Almeida, chief economist at BTG Pactual and former Treasury secretary.

“You shift from long-term financing, like the NTN-B, to shorter-term financing with LFTs, which have a maturity of up to six years. This creates a more fragile debt structure,” explains Mr. Almeida. “Selling an NTN-B at a 6.5% interest rate is very expensive. If the government is confident it can take steps to demonstrate its commitment to fiscal policy and bring down that interest rate, it might make sense. But if those actions don’t materialize, if market doubts persist, and if long-term rates remain at this elevated level, the government will be adding to the fragility of its debt financing.”

Mr. Rais, from Santander Asset Management, adds that there is ongoing debate among market participants over whether the Treasury is facing a lack of demand for NTN-Bs or is simply unwilling to accept the high market interest rates. “If the Treasury has demand but chooses not to issue NTN-Bs due to the high rates, it may be a risky move to leave the debt more exposed to post-fixed rates,” Mr. Rais says, highlighting the potential risks if the Selic rate needs to rise further.

*By Gabriel Roca, Gabriel Caldeira, Victor Rezende — São Paulo

Source: Valor International

https://valorinternational.globo.com/
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Lawsuits become R$2.6tri threat to federal government

Fiscal risk from legal disputes grows 66% since March, led by pensions case

09/19/2022

The Federal Supreme Court hold important, costly cases — Foto: Dorivan Marinho/SCO/STF

The Federal Supreme Court hold important, costly cases — Foto: Dorivan Marinho/SCO/STF

The fiscal risk calculated by the federal government for lawsuits filed against it has reached its most critical point in the last two years: R$2.6 trillion of impact to the taxpayer, according to the report to which Valor had access, updated in August. In comparison to the previous estimate, closed in March, there’s a 66% increase.

This figure refers to lawsuits whose chances of defeat in court have worsened in the last few months or have entered the government’s radar of concerns. Three cases are responsible for the increase. The main one is the so-called “lifetime review” — a revision of the social security retirement pensions to include years worked before 1994, which can increase the monthly amount received. The Federal Supreme Court (STF) has already formed a majority in favor of the pensioners and retirees but has not yet made the result of the judgment official.

Between March and August, the National Institute of Social Security (INSS) increased the estimated fiscal impact of the decision by more than 934%, to R$480 billion from R$46.4 billion, making this lawsuit the biggest focus of alert for the technicians who closely monitor the litigations.

According to these sources, the INSS started to consider the risk of the STF proclaiming a more generic thesis, that mentions not only retired people, but all the other insured people, such as those who receive death pension or sickness benefits. In respect for the accounting principle of prudence, the federal government always projects the worst-case scenario.

The other two cases were not alarming until then, but are now, adding to the total fiscal risk. One involves the incidence of social taxes PIS and Cofins on imports, with an impact of R$325 billion. The other discusses whether the granting of tax incentives interferes with the sales tax ICMS quota passed on to the municipalities. Defeat could cost the federal government around R$279 billion.

The STF has already recognized the general repercussion of both cases, which may go for trial by a panel of justices at any time. The rapporteurs, Justices Nunes Marques and Gilmar Mendes, respectively, may even do so directly in the virtual plenary session, whose agenda is not managed exclusively by the Court’s new chief justice Rosa Weber.

Even with a lower impact (R$151 billion), the government’s attention is also drawn to the appeal against the decision of the Superior Court of Justice (STJ) which admitted the special retirement of security guards who work with or without firearms, as long as they can prove the harmfulness of their activity. The case is also advanced in the Supreme Court.

Most of the R$ 2.6 trillion involves cases classified as “possible” risk of judicial defeat. There are also those of “probable” risk, whose unfavorable outcome to the federal government is even closer to happening, according to technical estimates. This portion is calculated at R$278.2 billion.

The number will be sent to Congress by October 10, for a fine-tuning of the 2023 budget before the congressional vote. Among the cases of “probable” risk is the discussion about the supplementation of the Fund for Maintenance and Development of Elementary Education (Fundeb), with a R$29.4 billion impact.

Another lawsuit to be included in the update of the so-called “Fiscal Risks Annex” of the budget is the one that discusses whether or not charities in the health, education, and social assistance segments have immunity from social security contributions. The federal government’s defeat could cost R$22.5 billion to the taxpayer.

Prior to last month, the highest total fiscal risk in two years had been recorded in August 2020 — R$2.3 trillion. In the meantime, the estimate has never fallen below R$1.8 trillion.

Sources in the economic team say that, although worrisome, the amount referring to the judicial demands will not necessarily be converted into court-ordered debts for next year. First, it is necessary to wait if the conviction will actually take place. In some cases, a change in the vote of just one Supreme Court justice would be enough to reverse the situation.

Moreover, even if the federal government is defeated, the execution of the sentence is not carried out exclusively by means of court-ordered payments — it can happen, for example, through an agreement for the compensation of debts. In other cases, an unfavorable judicial decision may only mean less revenue than expected.

A survey by the Economy Ministry shows that spending on judicial claims has been rising gradually. From 2014 to 2021, the share of sentences in total primary expenditure will jump to 3.4% from 1.8%. Sources points as reason the increases in litigation and the greater speed of Justice, with tools such as the virtual plenary.

The budget law foresees a total of R$73.99 billion in court-ordered debts for next year, of which R$22.31 billion in debts from previous years. If we consider the small value requests (RPV), which total R$26 billion, the expenses with judicial demands would exceed R$100 billion.

For public accounts specialist Leonardo Ribeiro, economic advisor to the Senate, the government needs to promote mechanisms to meet accounts to prevent these fiscal risks from becoming budget expenses. “One solution is the securitization of public sector assets and liabilities using market instruments. This offsetting of debts would be an element to restructure the federal government’s debts, mitigating fiscal risks arising from judicial decisions,” he explained.

Daniel Couri, head of the Independent Fiscal Institution (IFI), said that the judicial disputes certainly increase the fiscal risk of the federal government. “It is important to have clarity about these numbers and it seems to me that the federal government is moving in that direction. But dealing with such a risk is a problem when you have a high and expensive debt for the standards of emerging countries,” he said.

The Federal Attorney General’s Office (AGU) said that its role is to “evaluate and classify the fiscal risks of lawsuits filed against the federal government, independent agencies, or public foundations based on legal criteria.” It also stated that “the risk classification is subject to change as each case evolves within the Judiciary”. The AGU also said that in 2021 the court decisions favorable to the federal government avoided the disbursement of R$418 billion, “allowing these amounts to be directed to sectors such as health, security, and education.”

*By Luísa Martins, Edna Simão — Brasília

Source: Valor International

https://valorinternational.globo.com/
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Market expects new interest rate hike

Selic rate is expected to be raised to 13.25% on Wednesday because of worsening inflation and fiscal risk

06/13/2022

With the Selic policy interest rate already in double digits since the beginning of the year and in significantly contractionary territory, the Central Bank’s Monetary Policy Committee (Copom) meets this week to deliver a new interest rate increase. The market consensus points to a 50 basis points hike, which would take the basic rate to 13.25%.

The decision, however, became even more uncertain. The de-anchoring of inflation expectations for 2023 has intensified since the last decision and, in addition, the deterioration in the balance of fiscal risks has given additional support to the possibility of a further increase in the Selic in August – a scenario that has already been captured in the survey carried out by Valor.

The survey was carried out between Thursday and Friday, after the release of Brazil’s benchmark inflation index IPCA for May and included 91 financial institutions and consulting firms. The midpoint of the projections collected by Valor indicates that the Selic rate should be raised by 50 basis points this week and by another 25 bp in August, when it would reach 13.5%, at the end of the current monetary tightening cycle. In the survey released on May 30, the consensus pointed to a Selic rate of 13.25% at the end of the cycle.

The increase in expectations for the Selic rate comes in the wake of a further deterioration in expected inflation ahead. If, in the survey carried out before Copom’s May meeting, expectations for the IPCA in 2023 were at 4%, they are now at 4.6%. It is worth remembering the relevant horizon for monetary policy currently includes only calendar year 2023 and that next year’s inflation target is 3.25%.

Cassiana Fernandez — Foto: Divulgação

Cassiana Fernandez — Foto: Divulgação

“We expected that inflation would have already slowed down and the truth is that there is still inflationary pressure that is still very widespread and quite worrying in the composition,” notes J.P. Morgan’s chief economist for Brazil, Cassiana Fernandez. She also notes that this process has been reflected in the increase of inflationary expectations, especially in the relevant horizon for the Central Bank’s actions.

On Friday, J.P. Morgan began to see, in its baseline scenario, an even more extensive cycle of monetary tightening, with a final increase in the Selic in August. Ms. Fernandez notes that the Central Bank has promoted a very aggressive tightening cycle, raising the Selic by more than 1,000 bps since March 2021, which justifies the feeling that the cycle is nearing its end.

“The point is that it is still difficult to calibrate that end. And that is why I expect the Central Bank not only to deliver a 50 points hike, signaled in the last communication, but also to leave the door open for future movements, recognizing that, since the last meeting, there has been a worsening in the inflation scenario,” she says.

Fernando Gonçalves, superintendent of economic research at Itaú Unibanco, says it is unlikely that the Central Bank will interrupt the tightening cycle on Wednesday. “Even with the slightly better IPCA number for May, the cores are still extremely high and inflation has all the peculiarities of being persistent, quite widespread,” he says.

Itaú understands that Copom may indicate it foresees a new Selic increase in the August meeting. For Mr. Gonçalves, the statement may be similar to the last month’s decision, in which the committee gave strong signals, but opted to leave the next steps of monetary policy open, depending on the data.

Besides the two 50-point interest rate increases expected by Itaú, Mr. Gonçalves believes that in order to materialize the process of convergence of inflation expectations to the target, interest rates will need to remain at a high level for a very long period. “We can only see a cut in interest rates in the middle of next year. We know that long periods of relative stability in the Selic are not common in Brazil, but it will need to remain stationary to start exerting a greater influence of interest rates on the economy,” he argues.

Valor’s surveys have already captured an upward trend in expectations for the Selic rate at the end of 2023. Before the Copom meeting in May, the midpoint of the projections pointed to a basic interest rate of 9% next year. Now, the expectation is for a Selic at 9.75%, when bets that it will remain above 10% have increased.

The effort to try to cheapen fuel prices via tax exoneration is a fact expected to increase the uncertainties in the decision. “It has a considerably large deflationary potential, but the impacts would be temporary. Besides, the measures imply a worsening of the fiscal framework. As the discussion is ongoing, it may enter laterally in monetary policy via the balance of risks,” says economist Leonardo Costa, with ASA Investments.

For him, the measures worsen the balance of risks for meeting the targets in 2023. “Observing the attempts to control administered prices, I consider it an additional risk for the balance next year. Obviously you gain in inflation in the short term, at the cost of higher inflation in the medium term,” he points out.

Elisa Machado, chief economist at ARX Investimentos, who expects a Selic at 13.75% in the cycle, also believes that Copom may leave the next steps open, given the increased uncertainty and risks.

“Not only because of this view that there is no relief on the inflation side, but also because of these changes in [sales tax] ICMS, [social taxes] PIS/Cofins… On the one hand, this represents an increase in fiscal risk and. On the other hand, there would be a reduction of inflation in 2022, which would rise again in, disrupting the relevant horizon and throwing up inflation expectations for 2023,” emphasizes Ms. Machado.

Camila de Faria Lima, chief economist at Canvas Capital, defends a more open communication by the Central Bank given the high level of uncertainty. “However, I understand that if the Copom is effectively foreseeing the end of the high cycle, it would be better to make this vision explicit and, thus, guide market expectations,” she says. For her, this could happen with the indication of yet another residual hike or with the indication that the hike to be implemented this week marks the end of the cycle.

In its basic scenario, Canvas projects the Selic at 13.25% at the end of the cycle and 10% in 2023. Ms. Faria Lima recalls that the basic interest rate is already at a very contractionary level and that the most forceful effects on the economy are expected to appear in the second half. “Taking these aspects into account, in my opinion it is completely justifiable, in the scenario we have, to establish a credible inflation target for next year, extending the convergence to the center of the target to 2024,” she says.

Victor Candido, chief economist of RPS Capital, also adopts in his basic scenario the end of the cycle this week, with the Selic at 13.25%, although he points out the risks of a new high in August. For him, the Central Bank has already fulfilled the main part of its cycle and now only a “fine adjustment” remains. “I believe it will make the 50 bp hike that is priced into the curve and say it needs to evaluate the international scenario, the new internal risks and see how inflation itself will behave,” he predicts.

*By Victor Rezende, Gabriel Roca — São Paulo

Source: Valor International

https://valorinternational.globo.com/
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Pressure on long-term interest rates may remain high

Analysts say fiscal risk, approaching end of the tightening cycle will stir interest rate curve

06/09/2022

Luiz Armando Sedrani — Foto: Divulgação

Luiz Armando Sedrani — Foto: Divulgação

Even though they are at the highest level this year, long-term interest rates may not find so much support ahead for a stronger withdrawal of risk premiums. The market is already starting to see the end of the monetary tightening cycle over the coming months and, even though some agents see this event as important to unburden the market, the scenario for long-term rates is not very favorable, because fiscal and political risks continue to rise, at the same time as the Treasuries continue to go up.

The bets of the agents, therefore, have been concentrated on the steepening of the yield curve, that is, on a wider spread between long-term and short-term interest rates. At the moment, the spread between long and short rates is negative — in market jargon, the yield curve is inverted. On Wednesday, the difference between five- and ten-year interest rates was -0.635 points. In the view of market analysts, this difference tends to widen after the end of the monetary tightening cycle. This bet indicates the possibility of short interest rates falling significantly, or even the chance of long rates rising further.

“All the paths lead to a greater slope of the yield curve,” said Mauricio Oreng, head of macroeconomic research at Santander. He listed the factors that point to this scenario: the monetary tightening process in advanced economies, which has generated doubts about the natural level of interest rates; the inflation peak; the nearby end of Brazil’s benchmark interest rates Selic hike cycle; and the fiscal risks, which remain on the radar.

As for the international scenario, Mr. Oreng notes that international interest rates usually have an influence, especially on long-term rates. “We have this tightening scenario that may be faster than in other cycles for several central banks in developed countries and there is doubt whether in the future, when the cycle is over, interest rates will be at higher levels,” he said.

“The doubt is what the natural level of global interest rates will be in the future. Did we have an increase after all those inflationary impacts in the post-Covid, worsening of production chains, geopolitical tensions? It is a question mark that can bring the view that the natural interest rate in Brazil may have risen additionally,” Mr. Oreng said. He notes that, with the increase in fiscal risk during the pandemic, Brazil’s neutral interest rate rose to around 4% in real terms, in Santander’s calculations, and adds that it may be that the neutral interest rate will rise even more, depending on the global neutral interest rate.

As for domestic factors, fiscal risk is one of the issues that have often put pressure on long-term interest rates. In the last few days, the discussions about the sales ICMS tax and other tax cuts proposed by the federal government to contain fuel prices generated a strong rise in long-term rates, which reached their highest levels since October 2021. On Wednesday, the DI rate for January 2027 rose to 12.605% from 12.57%.

Besides the fiscal issues, one main factor cited by market analysts for betting on the steepening of the yield curve is the proximity of the end of the monetary tightening cycle. As soon as the Central Bank indicates that it has ended the process of raising interest rates, the market will start to include in the price of assets when the inverse movement will happen, which can generate a predisposition of the market to bet on the fall of shorter-term interest rates.

The CIO of BV Asset, Luiz Armando Sedrani, highlights the fact that Brazil is one of the few countries, among the world’s main economies, whose interest rate is already above current inflation levels, which can be translated into an advanced stage of the monetary tightening cycle.

According to him, global inflation caused by commodities may start to lose traction from now on. Moreover, when inflationary pressures more linked to economic activity in Brazil begin to give way, the disinflation movement may be faster than expected by financial agents. “This way, we have a preference for bets that benefit from the steepness of the yield curve. On the one hand, we believe that the Central Bank may cut rates sooner than expected. And, on the other hand, the increase in political risk also benefits the strategy,” states Mr. Sedrani.

In the context of better-than-expected fiscal results, the executive believes that it seems to be difficult to contain the government’s impetus to expand spending, especially in an election year. “We believe there will be pressure for more spending and the government will try to stimulate the economy. This concerns us, it has an impact on the yield curve, and so our bets are on steepening,” he argues.

Legacy Capital is another asset management company likely to increase positions that benefit from a greater spread between long and short interest rates, in view of the proximity of the end of Selic peak. “Whenever the cycle of interest rate hikes has been interrupted, the curve has steepened. For different reasons, but the slope always increases,” said Gustavo Pessoa, partner and manager of Legacy.

Legacy follows this process in Brazil and other countries, and it “has never failed,” Mr. Pessoa said. Thus, the firm maintains this position in the portfolio. “The difficulty is to understand when the cycle will be over. When the movement [of increasing the slope of the yield curve] happens, it tends to be abrupt and powerful,” he said.

Fernando Fenolio, the chief economist at WHG, evaluates that the bets on a wider spread between long and short interest rates are based on the view that the actions of the Central Bank are likely to influence short rates, while the fiscal risk can keep the long-term interest rate under pressure.

“If the Central Bank stops raising interest rates at the next meeting, in a scenario of high inflation and deteriorating expectations, the yield curve could steepen considerably with an inflation premium. It would mean a market reading that it [the monetary authority] would be interrupting the cycle at a moment when the work is not yet finished,” Mr. Fenolio said.

On the other hand, if the monetary authority ends the tightening cycle at a moment of cooling of current inflation and expectations, the inclination of the curve could occur at a lower magnitude. “In this case, the market would begin to project the interest rate cut cycle,” the economist said.

“But the premium for the fiscal situation could well dominate the steepening. In a more extreme scenario, if the fiscal risk rises too much, we could even see a need for the Central Bank to raise interest rates again and the curve to flatten again,” Mr. Fenolio said. He, however, stressed that this is not WHG’s baseline scenario.

By Victor Rezende, Gabriel Roca — São Paulo

Source: Valor International

https://valorinternational.globo.com/
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