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CONCLUSION: The central bank’s upcoming monetary policy meeting is a major catalyst that will either serve to put a floor in the BRL in the near-term, or set the currency on a sustainable [and continued] path lower vs. the USD – an outcome that would likely continue to drag Brazilian equities down with it over the intermediate term.

 

VIRTUAL PORTFOLIO: We sold our long position in Brazilian equities on MAY 22.

In this business, which demands positive P&L on an increasingly high frequency basis, being early = being wrong. Regarding Brazil specifically, our Global Macro risk management task from here [as always] is making a call on what we see coming down the pike vs. expectations. Bearish TREND and now bearish TRADE, Brazil’s benchmark Bovespa Index is signaling to us that fundamentals for Brazilian asset prices (both domestic and international) are likely to deteriorate in the immediate-to-intermediate term.

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As Keith highlighted in today’s Early Look, our proprietary three-factor (PRICE/VOLUME/VOLATILITY) quantitative model has proven to be far superior than traditional sell-side channel checks at signaling critical inflection points, as well as confirmation of many major trends across the global macro universe consisting of both single securities and broader asset classes. Currently, our model is confirming the “falling knife formation” in Brazilian equities, which forces us back to the drawing board on our once-bullish bottom-up view.

From an immediate-term perspective, the next major catalyst out of Brazil (aside from waking up to daily headlines from Finance Minster Guido Mantega), is the central bank’s upcoming monetary policy meeting (MAY 29-30). In short, we think there is a very, very dramatic need for them to put their foot down and stake their claim to sovereignty with regards to setting Brazilian monetary policy.

Regardless of whether or not there’s truth to the claim, many market participants are increasingly of the view that the central bank has become a mere extension of the central government and its drive to improve competitiveness via currency debasement and structurally lower the cost of capital throughout the Brazilian economy, which may require the central bank being significantly less vigilant in fighting inflation as it has been over the past ~10yrs or so. Up until recent weeks, such an outcome was being modeled into local economists’ NTM inflation expectations – which remain ~100bps above the median of the central bank’s +4.5 +/- 200bps target that continues to be guided to by Tombini as an EOY event.

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One key reason we think both analysts and market participants are worried about the central bank’s sovereignty is the recent change to disclosure regulation – specifically in that each board member’s vote on monetary policy will be made public going forward. The risk here is that members who are increasingly likely to succumb to the political pressure to lower interest rates for career risk management purposes (central bank board members can be fired at the will of the President in Brazil). That makes the upcoming action, accompanying commentary and guidance out of the central bank very important as it relates to reeling in market expectations for decreased central bank autonomy and, along with it, accelerating inflation expectations.

Per Banco Central do Brasil’s latest minutes: “… even considering that the activity recovery has occurred more slowly than anticipated, the Committee believes that, given the cumulative and lagged effects of policy actions implemented so far [i.e. 350bps of rate cuts], any movement of additional monetary easing should be conducted with parsimony.” We’ll see if they meet and extend their guidance – an outcome which our proprietary G/I/P model identifies as the most rational.

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Doing both would go a long way towards putting in a floor in the BRL/USD cross, which has dropped -6.1% from when we initially forecasted that we’d see limited downside relative to peer currencies over the intermediate term in our MAY 3 note titled, “WHAT THE HECK IS GOING ON IN BRAZIL?”. That decline is second only to the decline in the MXN/USD cross over that same duration within the region.

While we were clearly wrong here, three weeks does not a TREND make and we continue see asymmetric risk in what the Brazilian interest rate swaps and currency forwards markets are pricing in over the NTM relative to Brazil’s GROWTH/INFLATION dynamics – provided the central bank pushes back on the central government’s potentially inflationary policies. Alas, POLICY remains the lone holdout here and that can get investors right run over when central planners don’t behave according to expectations. For more on our view here, as well as a deep dive into the recent policy initiatives coming out of the central government, refer to our MAY 11 piece titled, “DON’T FIGHT THE FED… IN BRAZIL?”.

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All told, we can’t stress this enough: we expect both Brazil’s equity market and currency to experience continued downside over the intermediate term post the MAY 29-30 central bank meeting if their actions are perceived to be in line with the broader central plan of Brazilian policymakers. The strongest TREND-duration short thesis for Brazilian equities (i.e. the opposite of our long thesis) is quite consensus at this juncture, given that the Bovespa Index has indeed crashed from its MAR 13 YTD high (-20.1%).

Shorting Brazil from here requires true guts, but if the USD continues to make higher-highs over the intermediate-term – dragging cross-asset volatility up alongside it (the two are +94% correlated on an immediate-term duration) – Brazilian equities and the Brazilian real will likely continue to get tattooed if policymakers don’t commit to providing international investors with higher rates of expected return(s) via doing what they must to stem the tide/reverse the trend in the exchange rate (i.e. selling dollars, lowering cross-border IOF taxes, introducing a rhetorical floor for the BRL, hiking rates [not likely], etc.).

To this tune, the BRL is up over +2.8% vs. the USD on the day after being down earlier in the morning – a sign that the central bank might be buying dollars here and coming to the currency’s rescue. We’ll see if that this [potential] drive to support the currency becomes a trend.

As an aside, when cross-asset volatility breaks out, as it is doing currently, capital inflows to emerging markets slow markedly and those countries with current account deficits such as Brazil (2% of GDP) are at increasing risk of seeing their growth rates decelerate as investment and/or consumption growth slows.

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Lastly, given the recent acceleration in the pace of policy adjustments in Brazil, we thought it’d be helpful to compile the most recent headlines below in addition to Moshe Silver’s notes (our Portuguese-speaking CCO who mines the Brazilian press daily for incremental research nuggets): 

  • Latest Policy Maneuvers:
    • Brazil’s central government is considering cleaning up the balance sheets of certain state-owned banks through a transfer of “bad credits” to EMGEA, which is the government asset management company originally created to administer housing contracts held by Caixa Economica Federal under government housing programs.
    • Brazil will reduce a transaction tax charged on consumer loans; the said IOF tax on consumer credit will fall to 1.5% – the level it was at the start of 2011 – from the current 2.5%.
    • Brazil’s central bank will relax bank reserve requirements to specifically stimulate auto financing… should free up as much as 18 billion reais ($8.8 billion).
  • Moshe’s Notes:
    • Brazil central bank sees more rate cuts – speaking to O Globo, central banker Tombini says inflation should slow, from a current level of 5.1%, towards the 4.5% midpoint of the target range towards the end of 2012.  He rejected concerns over the recent decline in the real and fears of inflation.  “We recently laid in a course.  This course continues to be valid regarding future monetary policy,” he said.  “In the future, this process must be undertaken with frugality and care.” 
    • COPOM votes to be made public – starting with the upcoming meeting of COPOM – central bank monetary policy committee – the votes on monetary policy decisions will be published.  This goes against the traditional opacity that has been intended to shield the COPOM from political pressure.  In the past, the COPOM decision was presented as unified.  The decision has provoked heated debate, with many observers believing this will place pressure on individual bank directors to cave in to government pressure.  Partisans of the move claim it will provide transparency and shield dissenters with the “disinfectant of sunlight.”  This underscores what may be a new trend at the central bank – or perhaps what government officials hope will become a trend.  Over its history, the COPOM meetings have been marked by a high degree of unanimity.  Of the 153 COPOM meetings, only 25 have reported dissenting votes.
    • Treasury adds BNDES support – Brazil’s treasury is set to free up an additional R$ 10 billion to shore up BNDES lines of credit, as part of a program to add liquidity to the credit markets and stimulate economic expansion, after a weak Q1.  Government sources report that finance minister Mantega met with BNDES president last week and boosted the government’s lines of support for the bank from R$ 30 billion to R$ 45 billion, to show that the government will not skimp on resources to stimulate productivity.  Treasury lines of credit to BNDES are at subsidized below-market interest rates.  BDES says they will probably not draw down the entire amount this year, and will likely leave some over for 2013.  

Darius Dale

Senior Analyst