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CONCLUSION: We think Brazil is officially in a box from a fiscal and monetary policy front and any further dovish policy on either front would be in direct conflict with increasing fear of policymakers losing control over guiding domestic inflation towards official targets. As a result of this “box” we think Brazilian equities, currency and bonds could all be headed lower over the intermediate term as confusion about the outlook for policy breeds increasing contempt across Brazil’s financial markets.

This morning, Brazil’s JUL IGP-M inflation index (60% wholesale, 30% consumer prices and 10% construction costs) came in rather hot at +6.7% YoY from +5.1% in JUN; +6.7% is the highest YoY reading since OCT ‘11. Further, the MoM acceleration of +1.3% from +0.7% in JUN is the fastest sequential gain since NOV ’10 – the month QE2 was officially commenced. This acceleration of inflation in Brazil is very  much in-line with our written work on the subject (from our MAY 3 note titled, “WHAT THE HECK IS GOING ON IN BRAZIL?”):

“Additionally, recent weakness in the BRL/USD cross is eroding the currency’s marginal strength relative to global food and energy prices – which serves to threaten reported inflation statistics to the upside in the coming months. Notably, the IGP-M inflation index, which has been known to lead the benchmark IPCA CPI index by 2-6 months, bottomed in MAR. While we don’t see material upside in Brazil’s headline inflation rate over the intermediate term, this data point is in support of our model’s view that Brazilian CPI bottoms here in 2Q and accelerates in the back half of the year – likely preventing the central bank from reaching the midpoint of its inflation target of +4.5% (+/- 200bps), which it has repeatedly promised to accomplish by year’s end.”

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We maintain the aforementioned conclusion, which, coincidentally, is a view that is becoming more consensus on both the sell-side (via central bank survey data) and the buy-side (via an inflection in expectations for incremental monetary easing in the OIS market). We’d be remiss to not mention the fact that over 100,000 civil servants in Brazil – including employees of the central bank itself – are currently striking for wage increases that keep pace with the country’s consistently elevated rates of inflation.

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As a result of this proactively-predictable pickup in inflation, Brazil’s central bank is officially in the box we had been calling in MAY – which we identified then as a supportive factor for the BRL exchange rate(s) and, subsequently, Brazilian equities. Now, however, because they over-stimulated in recent months (-450bps of cuts since last AUG) and failed to adequately protect the currency from rising international price pressures, speculation that they’ll have to actually tighten monetary policy over the intermediate term should continue to grow.

Speculation around monetary tightening – or rather, the consensus realization that Brazil’s central bank has greatly exhausted its bullets on the stimulus front – will likely introduce incremental economic growth concerns that we’d view as negative for Brazilian equities on the margin. Additionally, the both the central bank and central government of Brazil have signaled that they are likely to continue implementing dovish policy over the intermediate term (Tombini indicated such in his latest statement; the Finance Ministry is actually planning to introduce further fiscal stimulus measures in AUG); that should drive future expectations for Brazilian real interest rates lower as inflation expectations pick up. That would be an incremental negative for the BRL over the intermediate term, which, in turn, would be an incremental negative for Brazilian equities for the following two reasons: 

  1. An increasingly subdued outlook for currency appreciation/an outlook for outright depreciation limits the appeal of Brazilian assets to international investors. Brazil, with a current account deficit of 2.1% of GDP, needs steady flows of international capital in order to sustain economic growth.
  2. A weaker currency – particularly vs. the USD – drives up the cost of servicing international debt as well as expenditures on FX and interest rate hedges for Brazilian corporations. Additionally, it drives up the cost of imports – from raw materials to capital goods – and erodes the gross margins of Brazilian corporations. All of this acts as a headwind to earnings growth. 

While not necessarily a factor in our TREND-duration outlook for the BRL, we do see the central bank’s planned failure to roll over the $4.5B of maturing currency swaps coming due tomorrow as a TRADE-duration negative for the currency (though a fair amount might be getting priced in today, as it BRL is down nearly -80bps vs. the USD intraday).

The quantitative setup in Brazil’s benchmark Bovespa equity index is akin to the outlook for Brazilian monetary and fiscal policy – stuck between a rock and a hard place. A sustained breakout above the TREND line (58,131) would signal to us that we’re wrong on our intermediate-term bearish thesis. A breakdown below the TRADE line (54,843) would be a signal to short Brazilian equities on any/all rallies to lower highs.

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All told, we think Brazil is officially in a box from a fiscal and monetary policy front and any further dovish policy on either front would be in direct conflict with increasing fear of policymakers losing control over guiding domestic inflation towards official targets. As a result of this “box” we think Brazilian equities, currency and bonds could all be headed lower over the intermediate term as confusion about the outlook for policy breeds increasing contempt across Brazil’s financial markets.

Darius Dale

Senior Analyst