Brazil’s inflation expectations are going the wrong way as investors fear the central bank won’t be bold enough to rein prices in.
Traders are piling into inflation-linked bonds, seeking protection from an expected acceleration in prices, as officials stick to their guidance that they will pause the rate-hiking cycle before borrowing costs reach the neutral level -- seen around 5.5% to 6% in Brazil. For investors, that won’t be enough to get inflation under control, especially if commodities keep rallying and surging wholesale prices get passed on.
The stronger demand for these notes, which even allowed the Treasury to double the size of a bond auction this week, is sending inflation breakevens through the roof. Brazil’s two-year rate has climbed 59 basis points this month to 5.43%, the highest in five years. Economists are also boosting their forecasts and already see inflation above the 3.5% target next year, according to a weekly central bank survey.
“Commodity prices, foreign-exchange behavior and this relatively dovish stance by the central bank are driving up the demand for linkers,” said Pedro Dreux, a money manager at Occam Brasil Gestao in Rio de Janeiro. “The central bank is putting too much faith in the models, but we think they should move faster.”
Inflation concerns are mounting across the world, forcing some central banks to rethink the loose monetary policies adopted last year to fight the economic impact of the pandemic. Brazil was one of the first countries in the developing world to embark on a tightening cycle, raising its benchmark rate by 150 basis points since March to 3.5%.
Still, inflation forecasts keep rising and numbers have exceeded estimates. Brazil’s consumer prices rose 6.76% in April from a year earlier, the most since late 2016, amid a rally in agricultural and metal prices and an improvement in the nation’s growth prospects. As the number of new Covid-19 cases and deaths slows down, banks including Goldman Sachs Group Inc. and Barclays Capital Inc. have lifted gross domestic product forecasts for this year.
On top of that, wholesale inflation is rising sharply, suggesting more pressure on consumer prices ahead. The IGP-M index, which is more focused on wholesale prices, is running at around 32%, more than 25 percentage points above the official inflation index. While the two gauges don’t necessarily walk together, that gap has never been so high and it suggests there’s room for companies to pass on higher production costs to consumers. Furthermore, recent droughts are leading to an increase in electricity prices that may last until the end of the year.
It’s not just Brazil where bond-market expectations for price gains are climbing, with the surge in commodity prices, central bank liquidity and a reviving economy all combining to lift breakevens globally. In the U.S., the world’s largest bond market, the 5-year breakeven rate on Treasuries this month jumped to 2.82%, a level unseen since 2005 and well above the Federal Reserve’s inflation target.
Brazil’s faster-than-forecast inflation is challenging the central bank’s plan to remove only part of the monetary stimulus currently underpinning Latin America’s largest economy. Officials have been saying price pressures are temporary and in the minutes to their last meeting they said inflation would fall below the 2022 target if the key rate is raised to the neutral level in the current cycle. For that reason, they have signaled they plan to pause the tightening later this year.
But traders aren’t buying into the central bank’s view. Swap rates price in more than 300 basis points in additional rate increases this year, which would take the Selic to 6.5%, above the neutral level. They also anticipate another 89 basis points in tightening in the first quarter of 2022.
In recent weeks, officials said the “partial normalization” path is as much as they can signal, though that could be adjusted if economic conditions change.
“Inflation pressure is lasting longer and this suggests the BCB needs to keep raising rates to prevent a contamination of next year’s forecasts,” said Caio Megale, chief economist of XP Investimentos, who expects the central bank to extend the tightening cycle.
The risk is that the central bank doesn’t meet markets’ hawkish expectations and that’s why demand for inflation-linked bonds is so strong. On Tuesday, Brazil’s Treasury raised 19.5 billion reais ($3.7 billion) through the auction of 4.7 million linkers, locally known as NTN-Bs, more than double the amount of notes offered in the previous two weeks. On Thursday, the Treasury increased the size of an offer of floating-rate bonds while reducing the amount of fixed-rate notes.
On top of inflation, the central bank also needs to take into account the fiscal outlook and the fact that the economy is still suffering the impact of the pandemic, even as prospects start to improve. One third of Brazil’s government debt is linked to the Selic rate and further hikes would increase interest expenses, adding pressure to public accounts.
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