News & analysis

The Central Bank of Brazil (BCB) has become accustom to deviating from its guidance recently. After surprising the markets with a 25 basis point cut at its May meeting, despite the fact that at its March meeting it had explicitly forecast a final cut of 50 basis points, yesterday’s decision was more drastic. For the first time in the current cycle of cuts, the BCB decided to hold rates, leaving the Selic rate at 10.50%.

While guidance from Bank officials didn’t steer in this direction ahead of both meetings, the data has supported a more gradual approach to easing. In particular, the latest monthly HICP data have shown that disinflation progress has stalled in Brazil. In May, not only did headline inflation rise from 3.69% in April to 3.93% year-on-year, but the underlying pace also surprised with an increase of 0.46%, confirming that it has been accelerating for two consecutive months now.

While this in itself favours the BCB holding policy at current levels, the fact that May’s decision to reduce the pace of easing to 25 basis points was the result of a very close vote, 5-4 in favour of slowing from 50bp cuts, made us doubt that a pause in the easing cycle was even an option weighed by some on the Copom.

Thus, we looked for a repeat in the voting pattern in our baseline scenario, with the four votes against maintaining the Selic rate again corresponding to the members appointed by the current government. To everyone’s surprise, however, this did not happen. Yesterday’s decision was the result of a unanimous vote. This is significant not only in the context of May’s politically divisive voting split, but also the current market backdrop, where investors have become increasingly concerned about the government’s pressure on the central bank as it struggles to meet its fiscal targets due in part because of the higher interest rate environment.

With its latest decision, the Copom have recaptured a defining characteristic of the BCB’s current monetary cycle: unanimity in its decisions

As the progress of talks on a more expansionary budget between the government and the representative chambers in charge of approving the new fiscal framework have undermined the Bank’s balance of risks, and considering the political division within Copom, we believe that a unanimous decision presents the best possible news for markets.

The decision should help to alleviate investor concerns around the BCB’s independence and its commitment to returning inflation to target, which in recent weeks have led to inflation expectations de-anchoring.

That said, it was not all good news from the BCB yesterday. Alongside the recent de-anchoring in inflation expectations, the government’s inability to meet its debt sustainability targets and its reluctance to cut expenditures to do so has crystalised the upside risks to the BCB’s inflation outlook. As a result, the BCB again revised up its baseline scenario for inflation from 3.8% to 4.0% for 2024 and from 3.3% to 3.4% for 2025.

Given the BCB decision marked a hawkish development, the extent to which local markets open stronger and the real consolidates any rally will depend on the news from the Lula administration. Recent headlines seem to point to a growing risk regarding Brazil’s debt sustainability, which has raised fears in markets that Brazil will miss its primary fiscal target this year and continue to struggle to control its deficit. Although interest payments are excluded from the government’s goal of eliminating the fiscal deficit by 2024, President Lula continues to claim that his government will achieve fiscal balance by increasing revenues and reducing interest rates. The latter has become more worrying from the point of view of the independence of the monetary authority when the president himself, Lula da Silva, stated a few days ago that, during the mandate of the next BCB Governor from January 2025, consideration will be given to introducing the level of growth in the Bank’s mandate. With Copom’s cards on the table, any backlash from government officials could see BRL sell-off even as local rates rise.

Given how damaging the period of tensions between the executive and the central bank in Q1 2023 was for investor confidence, any decline in USDBRL or BRL implied volatility on the back of the BCB’s more constructive decision should be viewed in the context of better entry points for hedges as the risk of another BCB-Lula feud remain elevated.

 

 

Author: 
María Marcos, FX Market Analyst

 

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