Brazil Quenches Dollar Thirst But Traders Want More Rate Hikes

(Bloomberg) -- Brazil's central bank is spending billions of dollars to curb the real's recent losses, but for traders nothing would be more effective than a hawkish nod from the monetary authority.

An aggressive approach toward inflation is key for the Brazilian currency to reverse a two-week slump that $2.1 billion in spot and swaps intervention since April 22 has failed to revert. Despite the recent declines, the real remains the world's best performing currency this year.

The fate of the real could come down to the words picked by the central bank in its rate decision statement on Wednesday, which may leave the door open to further tightening. Swap rates currently price in a full-point hike this week and a half-point increase in June. Anything more dovish than that will likely be badly received.

The central bank decision “will be important for the real's performance over the medium term,” said Danny Fang, a currency strategist at BBVA in New York. “The BCB's policy outlook is a bit unknown, which impacts the real's pricing.”

Officials signaled in the March meeting their intention to stop raising rates as early as May, saying the yearlong monetary tightening cycle was enough to bring inflation down to target next year. But higher-than-expected consumer prices data released since then fueled doubts not only about the central bank's policy outlook, but also about its forecasting models. While officials see inflation easing from 12% toward 3.25% next year, economists' median forecast is at 4.1%.

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Concern about inflation roaring back if the central bank follows the dovish path pushed long-end swap rates higher, with contracts due 2027 rising 85 basis points since second quarter begun. Short-term rates rose much less, leading the inverted front end of the curve to flatten.

While investors seem to be comfortable with the central bank making a pause after June, much of the market reaction may depend on how officials justify the pause. Saying they will wait to see the impact of the tightening could be better received than saying current rate hikes are enough to bring inflation to target.

“We're in a highly volatile market. Forecasting models are not working as they did before,” said Sergio Zanini, partner and portfolio manager at Galapagos Capital in Sao Paulo. “The market has a hard time understanding the reaction function of this central bank. They are risk takers.”