Oil drop gives little room for more Selic cuts

Since mid-May, the link between oil prices and short-term interest rates has weakened. As investors reassess the Selic’s path, other factors have gained weight as potential obstacles to deeper rate cuts: unanchored inflation expectations, still-high services inflation, and a more expansionary fiscal and credit policy backdrop, which has worsened perceptions of risk.

That explains why short-term rates have remained elevated even after oil fell from more than $100 a barrel to $75. Crude is now below the Central Bank’s own assumptions. In its Monetary Policy Report, the bank said it expected oil prices at $85 in the first quarter of 2027.

“The relationship between the yield curve and oil was very strong, and then suddenly it started to break down. The curve shifted higher, and I think that reflects broader concern about the fiscal impulse. The market is very likely pricing in a significant impulse, which should not allow for many more cuts,” said Fernando Gonçalves, head of economic research at Itaú Unibanco. He noted that the monetary authority included consumer stimulus in its balance of risks, which now has an upside asymmetry for inflation.

In an outlook update published in late June, Itaú made a marginal change to its interest-rate forecasts and now expects only one more 25-basis-point cut in the Selic, which would end the year at 14%. “We saw a substantial drop in oil, but Copom itself shifted to a tougher tone on inflation, which suggests very limited room for cuts,” Gonçalves said.

Gonçalves raises another point: the fall in oil helps reverse part of the currency appreciation seen earlier, offsetting some of the disinflationary effect. “When oil prices rose, Brazil’s trade outlook improved, with more foreign currency entering the country, and the exchange rate appreciated. Now, as that move reverses, the expectation is that the trade balance will not be as strong as previously thought, and that pushes the dollar higher. There is some compensation, even if it is not complete.”

In practice, Gonçalves said, “there is less room for rate cuts.”

Limited easing

The Copom digital options market tells a similar story. At Friday (3)’s close, the probability of a 25-basis-point Selic cut in August stood at 72%. But the likelihood that the easing cycle will continue beyond August is far from a consensus, despite the relief from oil prices. The probability of rates being held in September ended the week at 57%.

The decline in oil may lead some market participants to revise their IPCA inflation forecasts, said Santander economist, Marco Antonio Caruso. “This is a debate that is gaining traction and could create a downside bias in the short term. We, for example, lowered our IPCA forecast for the year to 5% from 5.2%, partly because of oil,” he said. Santander expects two more Selic cuts, in August and September, taking the benchmark rate to 13.75% by year-end.

Beyond oil prices, Caruso said, Copom’s latest communications suggest the committee sees monetary policy as already highly restrictive.

“All this engineering around alternative Selic scenarios suggests to me that this is a Central Bank that, in fact, sees the degree of monetary tightening as much greater than the average analyst does. If that is true, there is a cushion. Even using some conservative assumptions, such as worsening [Central Bank’s survey] Focus expectations and exchange-rate deterioration, it is possible to reach the Central Bank’s 3.2% projection for the first quarter of 2028 [released in the Monetary Policy Report] with the Selic at 13.75%,” Caruso said.

Central Bank communication

The monetary authority’s communication since the latest Copom decision continues to draw criticism from market participants, who see an implicit greater concern with activity than with inflation.

“Looking at what is written in the statement, the entire first section is consistent with a rate hike, not a cut. Even so, the Central Bank cuts the Selic… At the end of the day, the justification for the cut was very weak. Looking at the first quarter of 2028 because the model would indicate very abrupt volatility in macroeconomic variables… We are not talking about raising rates, but about keeping them unchanged. It left a very bad impression that, technically, the Central Bank brought elements that argued against cutting rates and still went ahead and cut,” said Marcos De Marchi, chief economist at Oriz Partners.

De Marchi said that, if oil continues to fall, part of the market may see room for the easing cycle to continue in August. “But since the start of the conflict, the government has tried to soften the pass-through from oil to consumers as much as possible. For that reason too, our inflation gain does not seem likely to be that significant, especially compared with what happens in the U.S., where pass-through is almost automatic,” he said.

Oriz still expects the Selic to remain at 14.25%. De Marchi also highlighted the widening “alligator mouth” between oil and short-term rates. “That is because of fiscal issues. There is no way around it.”

De Marchi pointed to recent developments he sees as negative, suggesting there is little room for risk premiums at the short end of the yield curve to ease. In addition to bills moving through Congress that point to higher spending, De Marchi mentioned the Federal Court of Accounts’ validation of public-policy operations outside the budget, which further weakens the Fiscal Responsibility Law, and Rio de Janeiro’s debt renegotiation with the federal government.

“The flow of news on public accounts is very poor. My scenario is still for the Selic at 14.25%, although the chance of one more adjustment has increased because of oil,” he said. “We are in a dilemma: should I base my cycle forecast on what I think needs to be done, or on what the Central Bank indicates it would like to do? I prefer to keep a cautious stance.”

Long-term expectations

At Itaú, Gonçalves does expect some relief in short-term expectations because of oil, but he does not see that spreading to longer horizons. “The impact of oil on 2028 inflation tends to be smaller. When I look at the unanchoring of 2028 expectations, I see Focus trying to assess how credible it is that the Central Bank will reach the target. The fact that there has been a recent increase is a sign that the market sees it as less credible that inflation will get close to the target.”

For Gonçalves, a credibility issue has emerged “and it has to do with the perception of a very expansionary fiscal policy at the moment, which signals that it will be difficult to make the necessary adjustment.”