Brazilian Traders Pile Into Rarest of Bets in Zero-Rates World

(Bloomberg) -- It is heresy in economic circles nowadays to talk about raising interest rates. With the virus still raging and economies still sputtering, rates need to be held at record lows for a long, long time, according to consensus thinking all over the globe.

Except in Brazil. Traders there are frantically driving up interest-rate futures in anticipation that policy makers will lift the 2% benchmark rate next month. Encouraged by debate among central bankers themselves about how soon to tighten monetary policy, traders have determined that at a minimum the Selic rate will be raised by a quarter point in March, and maybe even as much as a half point.

Either way, an increase would put Brazil in very rare territory. Central bankers in only one major economy in the world -- Turkey -- have lifted rates since the pandemic began. Like in Turkey, Brazil is grappling with concerns that are absent in most other countries: the possibility that inflation will surge after declines in the currency drove up the cost of imported goods. The real, down 23%, and the lira, down 19%, are two of the world's worst-performing currencies over the past year.

In Brazil's case, it was an experiment in massive fiscal stimulus that brought on much of the pressure on the currency. President Jair Bolsonaro rolled out a $57 billion package in 2020, which swelled the government's deficit to 13.7% of GDP, and is under mounting political pressure to unveil additional spending to help struggling Brazilians. While investors may be comfortable watching Latin American countries with better economic fundamentals, like Peru and Chile, emulate the kind of large-scale stimulus conducted by developed nations in the pandemic, they have been unnerved by it in Brazil.

Read More: Bolsonaro Newfound Appetite for Spending Has Markets on Edge

“Our balance of fiscal risks is worse than our peers,” said Gustavo Pessoa, a partner at the Sao Paulo-based hedge fund Legacy Capital who forecasts a half-point hike in March. “This has weighed on our currency and has contributed to rising inflation.”

Until recently expectations among investors and economists were broadly that the central bank would stay on hold until the end of 2021 when growth rebounded. But higher-than-anticipated inflation data along with a deteriorating fiscal outlook prompted the bank to scrap its forward guidance, signaling a possible hike despite a floundering recovery.

Brazil's relief spending helped the economy contract less than most regional peers in 2020 and also triggered a consumption boom among many Brazilians who rushed to stock up on pantry items. That, along with rising global commodity prices, caused food and beverage prices to jump 14% year-on-year.

Economists are raising their inflation expectations for the year after December consumer prices jumped by the most since 2003. The median forecast for this year's inflation rate rose to 3.5%, toward the 3.75% target, from 3.3% in December.

Brendan McKenna, a strategist at Wells Fargo in New York, revised his interest rate forecast last week and now expects a 25 basis point hike in March. Previously, he saw that happening only in the second half.

“Given the way inflation numbers have moved and the guidance from the central bank, we brought those forward,” he said. “We are looking for average inflation this year of around 4%.”

The inflation pickup is on the central bank's radar. The minutes of the last meeting showed officials already discussed increasing rates due to persistent price pressures. The hawkish tone of the document triggered a jump in swap rates, which now price in a 34 basis point hike in March, from less than 15 basis points in early January.

Days later, Central Bank President Roberto Campos Neto said officials still see rising inflation in Brazil as having a temporary component, contrasting with the more hawkish approach they used in the minutes.

“There was a consensus that we should wait for a series of inflation and activity data before normalizing rates,” Campos Neto said.

Read More: Brazil's Campos Neto Says Short-Term Inflation May Speed Up

A rate hike in March would be the first by the monetary authority since July 2015. Back then, the Selic was at a nine-year high of 14.25% with inflation running at more than double the official target. While an increase would still keep Brazil's rates below those of peers like Mexico and South Africa, the move could offer some support to its battered currency.

The real has weakened about 40% in the past four years as investors exited what was once among the most attractive carry trades in the world. Last year the real fell more than any other emerging-market currency except the Argentine peso.

After what looked like a V-shaped recovery in the second quarter of 2020, the Brazilian economy has been gradually losing steam and risks crashing again in the beginning of the year as a second wave of the virus prompts local authorities to reimpose restrictions.

Consumer confidence fell for four consecutive months through January, the services sector still hasn't recovered and even retail sales, which had been leading the economic rebound, unexpectedly fell in November. The unemployment rate stands at 14.1%, near a record.

Fiscal concerns are also casting doubt on the sustainability of record low rates. A spending cap that limits government expenditures established in 2016 is under threat by growing demands, prompting Economy Minister Paulo Guedes to warn last week that the potential impact of losing control of fiscal dynamics could be equivalent to an atomic bomb.

Members of the economic team are privately acknowledging that another cash injection may be inevitable. At an event last week, Guedes left the door open, saying that the government “will know how to act just like it did last year” if a resurgent pandemic starts bringing some “1,500 or 1,600 deaths per day.”

“The Covid-19 deterioration is the additional new problem,” said Juan Prada, a currency strategist at Barclays Capital Inc in New York, who expects a rate increase in May. “This puts more pressure on fiscal accounts.”

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