Brazil: Christmas Treat For Believers
For all of those out there who have recognised that high inflation is so 2008, and with the risk of deflationary pressures mounting believe that no credible central bank – even in emerging markets – will consider raising interest rates, there may be an early Christmas treat. By that I don’t mean appealing high street pre-Christmas sales as global retailers try to avert what could become one of the worst Christmas seasons in decades. I am referring to Brazilian DI interest rate swap contracts, which still seem to be pricing in interest rate hikes in Brazil. In my view, rates are going nowhere but down. Allow me to explain:
For quite a long time now, I have been saying that Brazil’s central bank is possibly one of the most credible monetary institutions in the emerging market universe. They aggressively hiked interest rates the moment they sensed that inflation expectations in Brazil were on the rise. By the same token, I now believe that they have put an end to their monetary tightening cycle and, indeed, will start cutting interest rates in 2009, in an effort to ease tighter credit conditions and drying up liquidity in the financial system. In short, I believe that Brazilian central bankers have little doubt that in 2009 deflation and slower economic growth will be the main challenges.
Brazil – Implied Breakeven Inflation and 12-month CPI Expectations
Looking at official inflation expectations, though, my view does not seem to be shared by everyone. 12-month headline inflation expectations are still well above the 5.0% mark, and the short end of the local DI interest rate swap curve appears to be pricing in further rate hikes by the Banco Central do Brasil. The January 2010 DI swap contract currently yields 14.55%, while the average daily DI rate stands at 13.15%, a spread of 140 basis points (bps). To be fair, mid-month consumer price inflation came in at a more than three-year high on November 26, at 6.5% year-on-year, and retail sales in Brazil remained at higher-than-expected levels back in September. Nevertheless, I am a firm believer that bond markets always get it right, and in this case, too, they don’t disappoint.
Implied 10-year breakeven inflation (the spread between the 10-year inflation linked treasury bond and the 10-year fixed rate treasury bond) suggests that markets expect inflation to come down quite sharply in the near future. The breakeven spread narrowed from 804bps back in July to 687bps on November 21, implying that inflation is set to slow.
Brazil – January 2010 DI Swap Contract
On November 18, I suggested in Business Monitor Online that the yield on the January 2010 DI swap contract would start to compress from 15.10% towards 14.60%, which it took out only a few days later. Indeed, at 14.55% the yield has dropped by some 55bps since November 18, and looks set for further narrowing, in line with my monetary policy outlook. By assuming a receiver position on the January 2010 DI swap contract, therefore, I believe there is a nice dividend to be paid. Brazil’s Selic target rate currently stands at 13.75%, and in my view is set to fall possibly to as low as 12.50% by the end of next year. As such, for those who share my view that monetary policymakers will no longer hike interest rates in Brazil, the DI swap market may offer an attractive Christmas deal.