Brazil central bank cut rates by 50 bp to 12.0% by a vote of 5-2, with the 2 dissenters voting for steady rates. No change was expected. However, we note that there was a real split between what economists and traders were pricing in. Weekly central bank survey of analysts shows year-end rate was expected at 12.5%. However, fixed income traders have priced in up to 75 bp of easing by year-end. After today’s decision, we suspect that those expectations will ratchet up further since there are two more meetings left this year, October 18/19 and November 29/30. We believe that the central bank is wrong to cut rates now. Yes, the global outlook remains questionable, but exports are less than 10% of GDP in Brazil. Domestic demand is a much more important driver for the economy, and that remains strong. Price pressures have eased, but remain high enough to call into question this decision to cut so soon.
The COPOM statement noted that “in the relevant time frame, the balance of inflationary risks is becoming more favorable. In this regard, the revision of the outlook for fiscal policy also points in this direction.” It placed great emphasis on the deteriorating external outlook, but as we noted earlier, the domestic outlook is much more important. In that regard, we disagree with its assessment that “a moderate adjustment in the benchmark rate is consistent with a scenario of inflation converging to the target in 2012.” We believe instead that there is still risk of inflation overshoot next year, especially since it appears that fiscal policy is not going to be all that restrictive going forward. The government just proposed an almost 15% hike in the nominal minimum wage for 2012, which has far-reaching impact since pensions and other wage contracts are indexed to this measure. Furthermore, the government just proposed a primary surplus target for 2012 at 2.5% of GDP vs. 3% for 2011. While looser monetary policy might be justified due to tighter fiscal policy in the current weak global environment, we think that recent fiscal tightening won’t be maintained.
New central bank chief Tombini is supposed to be establishing his credibility, not damaging it, and yet the decision to cut will weigh on his standing with markets. We think that currency considerations are coloring the central bank’s policy decisions, just as it has dictated other policy responses during this crisis. While the 12% SELIC rate still stands out in the elusive quest for carry, we warn that Brazil really risks damaging its credibility further. While most EM central banks have moved into dovish wait-and-see stances, very few have cut rates during this cycle. Besides Brazil, only Turkey has this distinction and we’ve seen markets punish the lira in recent weeks. While the underlying fundamentals are much stronger in Brazil than in Turkey, we simply point out that market credibility is something that should not be taken for granted.
The decision to cut may help the Bovespa over the near-term, but could hurt stocks over the medium-term if markets believe that Brazil is moving further behind the inflation curve. BRL has performed well during this recent period of heightened market volatility, but that will be tough to sustain in light of this rate cut. While we had expected BRL to perform well in the coming months, this surprise decision will likely weigh on the currency and we now expect the real to start underperforming within EM. Implied yield on 1-month BRL NDF was around 7% before this decision was announced, which is on the low end of recent ranges, and so the 1.55 level in USD/BRL may thus prove even tougher to crack in the coming days. We do not think this is the start of a huge bear market for BRL and Brazil assets, but is enough to limit gains when compared to the wider EM universe.
