OUTLOOK FOR BRAZILIAN INTEREST RATES: READ THE FINE PRINT

Conclusion: We see Brazilian interest rates increasing over the intermediate term as president-elect Dilma Rousseff will likely fail to contain inflation early in her term.

Brazil’s CPI accelerated meaningfully in October to +5.2% YoY from +4.7% YoY in September, marking the second straight monthly acceleration from its August low of +4.5% YoY. Driven largely by gains in food prices (57% of the increase), October’s CPI report comes in line with our expectations for accelerating inflation globally on the heels of QE2-based speculation, as Bernanke dares investors to lever up and chase yield globally.

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More specifically as it pertains to the Brazilian economy, we’re starting to see interesting commentary out of president-elect Dilma Rousseff regarding the direction of public spending and fiscal policy. Moreover, two blatant shifts in rhetoric have her playing right into our expectations that she will be unable to contain public spending and debt accrual early in her term:

On the campaign trail, Rousseff vowed to reduce Brazil’s public debt to 28-30% of GDP from the current 42% by 2014. Now she is only committing to a more modest 400bps reduction over an unspecified period. Also, as recently as 11/3, she said she is seriously considering raising the monthly minimum wage to more than 700 reais ($412) by 2014 for a CAGR of 8.2%, which is greater than the 5.5% increase in 2011 under current President Lula’s budget. Further potential strains to the government’s budget include her commitment to reducing payroll taxes, levies on investment and taxes on prescription drugs, sanitation and electricity.

The Brazilian bond market has reacted in line with the aforementioned shifts in rhetoric. Yields on Brazil’s most actively traded debt due in 2017 have hiked 74bps since 10/15, which is roughly around the time it became evident that Rousseff would win the runoff presidential election set for 10/31. In addition to the Dilma factor, the Brazilian bond market has been correctly pricing in accelerating inflation since foreign investor participation became marginalized as a result of the central bank’s recent tax hikes on foreign inflows of capital. The Brazilian bond market is no longer just an attractive market for foreign yield-chasing capital; as such, the domestic investor base is re-pricing Brazilian government bonds as a result of their more-informed outlook for Brazilian inflation.

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Further supporting the outlook for accelerated inflation is a healthy and robust Brazilian consumer base, which is being supported by a significant confluence of tailwinds: Brazil’s unemployment rate decelerated 50bps MoM to a record low in September, 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 Brazilian inflation and interest rates 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. Furthermore, we remain bullish on the Brazilian consumer as one of the top long-term TAIL consumer plays in global macro. The intermediate term inflation and interest rate headwinds are, however, something to consider as it relates to the entry/exit timing on any investments.

Darius Dale

Analyst