On 10/01/17, the Monetary Policy Committee (COPOM) of the Central Bank of Brazil (BCB) took another step in the monetary easing cycle, cutting the benchmark central bank rate (Selic) by 75 basis points (bp) to 13%. This was triple the size of the two previous rate cuts and 25bp more than the market had expected.
Monetary easing started in October 2016…
After a sequence of 16 rate increases from 7.25% to a peak of 14.25%, the BCB first cut the benchmark rate by 25bp on 29 October 2016 (see Exhibit 1 below), primarily on the back of receding inflation. Disinflation also explained the second rate cut to 13.75% on 29 November 2016, though flagging momentum in economic activity notably reinforced the rationale for the move. The COPOM noted that growth indicators “failed to show a reversal that should be expected in a scenario of natural fluctuations of economic activity around stabilisation periods”. Yet the BCB refrained from a more aggressive monetary easing, arguing that a more uncertain global backdrop after the election of Donald Trump could trigger second-round effects on inflation via the weakening of Brazil’s currency.
…and has picked up the pace
COPOM members by then had already hinted at an acceleration in the pace of monetary easing should economic activity fail to show clearer signs of recovery, raising the odds for a bigger move subsequently. Further softening growth and quickening disinflation did indeed prompt the BCB to act more decisively this time around (see Exhibit 1). Without doubt the resilience of the Brazilian real in the wake of the US elections added strong support to this decision, as did the public spending cap reform, which had passed both houses of parliament by mid-December 2016. As this reform basically freezes public spending in real terms, it spells a large additional dose of fiscal austerity in the future.
Exhibit 1: Having peaked at 14.25% between mid-2015 and late 2016 the central bank of Brazil has now lowered its benchmark rate by a total of 1.25% since embarking on a monetary easing cycle on 29/10/16 – the graph shows changes in the BCB’s official Selic rate and Brazil’s rate of inflation between 2007 and 16/01/17.
Signs of improvement
Meanwhile Brazil’s macroeconomic backdrop remains very challenging. Manufacturing confidence has recovered somewhat from recent lows, but remains largely at recessionary levels. Industrial production has improved, but it is nonetheless still contracting (see Exhibit 2). Businesses have deleveraged significantly already, but given still-depressed capacity utilisation rates, low profitability, and high debt levels, corporate deleveraging is likely not over yet.
This process will further pressure employment and nominal wages and thus consumption (see Exhibit 3), all the more so as household debt servicing remains high (see Exhibit 4). Additionally, the government seems confident that its key pension system reform will pass Congress in the first half of 2017, which would add to the pressure on growth from fiscal austerity. Since pensions represent 42% of primary public spending, the government needs this reform to meet its public spending cap over the medium term. The reform will essentially fix the minimum retirement age at 65 and the minimum contribution period for all at 25 years.
Exhibit 2: The worst of the contraction in industrial production in Brazil appears to be behind us (although it is not over) – the graph shows 12-month (YoY) and two-month % changes in Brazilian industrial production between 2011 and 19/01/17.
Exhibit 3: Corporate deleveraging in Brazil is probably not over yet either. This process will likely constrain job creation, nominal wages and thus consumption –the graph shows annual % changes in retail sales (RHS) and the unemployment rate in Brazil for the period between 2011 and 19/01/17.
Exhibit 4: Household debt servicing remains high in Brazil – the graph shows household debt service as a percentage of disposable income from 2005 to 19/01/17.
Scope for more monetary easing
Given a still substantial amount of slack in the economy and the intensification of fiscal austerity, a return to real GDP growth of 0.2% in 2017 would not prevent inflation from slowing further (growth estimate from the IMF; Bloomberg consensus forecasts are for 0.5% GDP growth). We concur with the consensus estimate that inflation might fall to 4.5% by year-end. The BCB is even more sanguine, forecasting inflation to end 2017 at 4% and 2018 at 3.4%.
All this speaks for Selic rates to be cut substantially further this year and likely next year, too. We believe the Selic could end 2017 at 9.5% versus the 9.85% expected by the market (Bloomberg). We believe bonds could rally more in the next few months, although the markets have priced in most of the good news already (see Exhibit 5). For bond yields to continue easing on a longer time horizon, the government will have to convince the market of its ability to bring public debt back on to a sustainable path.
Exhibit 5: The Brazilian bond market has, in our view, already priced in most of the good news – the graph shows changes in the shape of the Brazilian yield curve between 20/01/16 and 20/01/17.
Mind the risks
Risks to this scenario are plentiful. Local risks are mainly linked to the ongoing investigations into the ‘car wash’ corruption case (Operação Lava Jato), which could weaken the government and delay structural macroeconomic reforms.
The main risks on the global front, also stressed by the BCB since resuming its monetary easing process, are “the uncertainties associated with possible changes in economic policy in the United States”. A rise in US yields leading to a strengthening of the greenback would undoubtedly pressure the real as external financing costs would increase.
However, the better commodity price environment and resulting improvement of Brazil’s terms of trade as well as potential inflows into Brazilian fixed income and the resumption of foreign exchange swaps by the BCB should limit pressures on the currency. It is worth mentioning that Brazil’s external vulnerabilities have visibly moderated (see Exhibit 6), while real rates are expected to remain high in relative terms. This should cushion a decline in the BRL to around 3.50 per US dollar in the medium term.
Exhibit 6: Brazil’s dependence on foreign capital has fallen – the graph shows changes in Brazil’s current account balance and net foreign direct investment in Brazil between 2000 and 19/01/17.
Source: Thomson Reuters Datastream as of 19/01/17
In brief, in light of a still weak economic context and increasing fiscal austerity, we expect markedly more monetary easing. This should support the Brazilian fixed-income market, but the currency might suffer from a narrowing spread with US Treasuries. A more durable slide in yields will only materialize if the government manages to put public finances back on a sustainable path.
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