Colombia Hikes Rates, Latin America Yields Very Attractive

By Win Thin

Colombia surprised markets with a 25 bp hike to 3.25% late Friday, and marks the first hike of the tightening cycle as the central bank tries to get back ahead of the inflation curve. The deciding factor behind the hike was likely rising inflation expectations, as the monthly central bank survey shows inflation seen at 3.61% at end-2011 and 3.58% at end-2012. CPI rose 3.4% y/y in January and is expected to rise further above the bank’s 3% target to 3.6% y/y in February. While the bank has a tolerance band of 2-4%, it was becoming increasingly clear that a monetary response was needed as Colombia was increasingly viewed as behind the curve. Not only was COP the worst Latin American performer in February at -2% vs. USD (second worst in all of EM), but the local bond curve steepened too in February and boosted borrowing costs for the government.

We believe COP is backed by solid fundamentals and will regain some of its attractiveness if Colombia policy-makers follow up with more efforts to re-establish credibility, which we expect. For USD/COP, we see a trading range of 1835-1935 over the next several weeks. Since we are near the top of that range, we would look to establish long COP positions as we near retracement levels around 1912 and 1936. We target the January low around 1835, but markets will get nervous near 1800. Peso strength has been an issue and officials have said they won’t rule out further FX intervention, but have also stressed that capital controls are viewed as a last resort.

With Brazil, Chile and Peru already continuing to hike rates, Latin America is turning out to perhaps be the best EM region in terms of combining high yields and strong fundamentals. As a net commodity importer, Asia is more susceptible to negative economic fallout from high commodity prices, while the policy response there has been lacking given the region’s reliance on weak exchange rates that has resulted in an aversion to hiking rates. Just to give some perspective on potential tightening in Latin America, we note that pre-crisis interest rates were much higher than current levels. Brazil (13.75% vs. 11.25% currently), Chile (8.25% vs. 3.5% currently), Colombia (10.0% vs. 3.25% currently), Mexico (8.25% vs. 4.5% currently), and Peru (6.5% vs. 3.5% currently) all have room to go higher on rates. We think Chile and Peru are ahead of the inflation curve, with Brazil and Mexico at the curve. With this latest move, Colombia has made an important first step in moving from behind the curve to be closer to Brazil and Mexico being at the curve.