Brazil Rates To Head Higher In 2011 Even As BRL Gains, Current Account Gap Widens

by Win Thin

Brazil central bank starts its two day meeting Tuesday, and market is looking for rates to be kept steady at 10.75%.  Though rates are expected to remain steady through 2010, market is looking for tightening to resume next year and rates to end 2011 at 11.75%.  September IPCA rose 4.7% from 4.5% in August.  More worrisome, wholesale IGP-M inflation for September rose 7.8% y/y vs. 7.0% y/y in August and was the highest since Feb 09.  Real economic data have softened but remain strong enough to worry about ongoing price pressures, and recent inflation data bear this out.  With Brazil continuing to suck in foreign money with rates at 10.75%, a restart of the tightening cycle next year would presumably keep those flows intact.  Most recent polls show Rousseff holding a slim lead over Serra for the October 31 second round vote.  We remain hesitant to make any currency calls with regards to the election, as we believe markets are fine with either Rousseff or Serra.  However, we believe that Serra offers less risk over the medium-term.

If the benign EM backdrop continues, then we see continued demand for BRL.  USD/BRL traded below 1.65 last week, a new low for this cycle, despite the recent hike in the IOF.  As such, it’s no surprise that policy-makers are mulling new tax measures and we fully expect further policy changes as the longer BRL trades below 1.70, the higher the odds of further capital control measures (see our recent comment “Is Brazil Considering Encaje-Type Approach To BRL Strength?”).  We warn that caution is warranted in BRL at current levels near 1.65.  Post-devaluation low for USD/BRL is around 1.5550 but seems unlikely to be tested given what we see as negative Brazil risks that are developing.  Besides the event risks (from politics and capital controls), we note that the external accounts have turned more BRL-negative, as the current account (CA) deficit widens and FDI flattens out.  The so-called basic balance (CA+FDI) turned sharply negative in 2010 and continues to widen.  The strong real coupled with the strong recovery has led the current account to deteriorate sharply in recent months.

Win Thin | Global Head Of Emerging Markets Strategy