Conclusion: Recent moves in the Brazilian bond market have been attributed to the “currency war”, but analysis of the fundamentals suggest the moves are warranted. While we don’t currently have a position, we remain favorably disposed to the Brazilian real against the U.S. Dollar over the long term.
Yesterday, Brazilian Treasury officials walked away from a debt auction for the first time since July 22, citing bids that were deemed “unreasonable”. Why they think bids are unreasonable after effectively squeezing out half of the investor base, is beyond us. Earlier in the week, Brazilian Finance Minister Guido Mantega raised taxes on foreign inflows on fixed income investments (for the second time this month) to 6% (from prev. 4%) and to 6% on margin deposits for futures (from prev. 0.38%). A loophole that allowed Brazilian financial institutions to swap assets to foreigners was also closed.
The aggressive move to curb real appreciation brought on by inflows of dollars has triggered a bond market sell-off, with yields on Brazil’s longest fixed-rate securities increasing 60bps this week to 12.08%. Today’s failed auction highlights the lack of domestic demand needed to sustain Brazil’s “low” interest rates, causing Treasury Secretary Arno Augustin to suggest Brazil will have to accelerate international sales of real-linked bonds to counter waning domestic demand.
Brazil, like every other emerging market growth country, has been guilty of riding the yield-chasing liquidity wave brought on by expectations of QE2 in America. And while self-imposed, yesterday’s failed auction tells us exactly what direction the real is headed alongside Brazilian interest rates – up.
Mantega may be successful in slowing down the rate of real appreciation vs. the dollar in the intermediate term with taxes and regulation, but longer term, the fundamentals driving Brazilian interest rates higher will be tough for him to overcome:
Fiscal Policy: The latest polls show voter support for Lula endorsee Dilma Rousseff is growing; she currently has an 11-12% margin over rival Jose Serra and is likely to win the October 31st runoff election, barring any catastrophic campaign mistakes. This is meaningful as it relates to the direction of Brazil’s debt/deficits, as she is on record saying promoting spending cuts is a “crime”. Her fiscal policies are in stark contrast to the much more austere Serra, whose previous surge in the polls sparked a bond market rally. Currently, Brazilian government spending is growing more than twice the rate of GDP, and with Rousseff’s promise for continuity with Lula’s welfare policies, we don’t see that changing anytime soon. Further, her lax spending policies create incremental support for the next factor we outline below:
Inflation: September marked the first sequential uptick in Brazilian inflation in five months, coming in at +4.7% YoY vs. +4.5% in August. Prior to that, inflation was being tamed by the strengthening real, which is up around 3% YTD. We have been increasingly cognizant of the likelihood that the dollar finds an intermediate-term bottom around in the $78-$82 range. Should the dollar strengthen marginally over the next three months, as we expect it to, we will see downward pressure on the real over the near term, limiting Brazil’s ability to fight inflation with FX appreciation alone.
Moreover, demand from Brazilian consumers is being supported by a significant confluence of tailwinds. Brazil’s unemployment rate fell 50bps MoM to a record low in August, coming in at 6.2%. Average real incomes also increased +1.3% MoM and +6.2% YoY and the latest data (April-July) show Brazilian consumer borrowing rates are at the lowest level since 1995 (6.74% per month).
All told, the direction of fiscal policy and consumer demand will continue to put upward pressure on Brazil’s inflation rate over the intermediate-to-long term, necessitating the need for future rate hikes. While we don’t currently have a position, we remain favorably disposed to the Brazilian real against the U.S. Dollar over the long term, largely based on diverging growth prospects. As mentioned, over the intermediate term, the dollar could catch a bid from 1) hawkish fiscal rhetoric from the likely-to-be Republican Congress; 2) mean reversion; and 3) widespread reflexive declines in equities and commodities globally.