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Brazil's Swap Curve Tremors: Insights on the Central Bank's Rate Cut Rift


Robert Tavares

May 13, 2024 - 18:55 pm


Central Bank Friction Shakes Brazil's Interest Rate Forecasts

In a recent development, the Brazilian central bank issued a statement that revealed a stark divide within its board. This disclosure had a profound effect on the country's swap curve, which now suggests lesser rate cuts than what market traders and analysts have anticipated.

The central bank took a step to reduce the benchmark interest rate by a modest 25 basis points, bringing it to 10.5% last week. While this move aligned with many forecasts, the associated statement—which highlighted a split vote and an attempt to balance dovish and hawkish perspectives—caused a degree of trepidation. The announcement led the local swap curve to respond as though an unexpected turn of events had taken place.

Notably, all four officials who supported a more substantial rate cut were appointees of President Luiz Inacio Lula da Silva. This alignment suggested to market participants that the central bank's staunch dedication to battling inflation might weaken as Governor Roberto Campos Neto's term concludes later in the year. Following this, the mid and long sections of the curve saw a steepening, while long-term maturities experienced an increase in rates. Moreover, market disruptions were evident as 'stops'—which occur when traders simultaneously seek to diminish risk—hindered the decline of short-term DI contracts.

As matters stand, the curve indicates an expectation of merely an additional 13 basis points in cuts for the current cycle. This reluctance to forecast a lower Selic rate, despite widespread beliefs that further cuts in borrowing costs are on the horizon, underscores the trader's hesitancy. The main cause of their caution stems from high levels of uncertainty on the international stage, particularly given the obscure trajectory of United States monetary policy. This hesitancy prevails although any dovish signals from the Federal Reserve could prompt a recalibration of short-maturing swaps.

Rafael Ihara, Chief Economist at Meraki Capital, expressed his belief in the potential for Brazil's central bank to continue rate reductions in the latter half of the year, provided there's positive momentum from U.S. inflation metrics.

Adding to the cautious sentiment are the fiscal risks presented by Brazil's adjustment of its fiscal target for 2025, coupled with the complexities that have arisen in estimating the financial repercussions of the assistance being provided to the Rio Grande do Sul state, currently grappling with disastrous floods.

For a more in-depth analysis, one can read further on this topic as analyzed by several Brazil experts who have adjusted their rate forecasts in light of the central bank's divided stance on policy. (Read more here)

Despite the curve's current suggestion, many economists maintain a skeptical view over the idea of a terminal Selic rate exceeding 10.25%. Their skepticism stems from the fact that inflation is trending towards the target rate, and core CPI has shown more favorable results. Recently released data for April revealed inflation at 3.69%, sitting comfortably within the central bank's target range of 1.5-4.5%.

The strategists from JPMorgan, including Luis Oganes, have pointed out that the Brazilian central bank has room to reduce interest rates further than what's currently projected in the market. They added that Mexico, after deciding to maintain unchanged rates, also possesses the capacity to make future rate cuts.

They emphasized, "As the dust settles around Fed expectations and currencies recover, we do not think that market pricing for end-of-cycle real rates above 6% in both countries is justified."

All attention now turns to the central bank's upcoming release of the minutes from its most recent policy decision, expected on Tuesday. Analysts and investors alike will be looking for explanations to justify the hawkish tones in the previous statement despite almost half the board voting for a greater rate cut. A failure to provide clear rationale might continue to exert upward pressure on swap rates.

As Bloomberg assisted by Giovanna Bellotti Azevedo and Vinícius Andrade reported on these current market dynamics, we await further developments. The said reporting can be attributed to ©2024 Bloomberg L.P.

In summary, the current situation encapsulates the delicate balance central banks across the globe are attempting to maintain. As they navigate through economic pressures, international monetary policies, and internal divisions, the ripple effects continue to be felt across financial markets. Brazil's swap curve predicament illu