Another Crossroad for Brazil

This could be a decisive week for Brazil as the toxic mixture of complicated politics, worsening basic principles and financial market stress comes to the fore.  These days, the congress is supposed to vote on whether to uphold or overturn the decision by President Rousseff to veto a sharp increase in spending. 

If the veto overturns, it would threaten the actual government’s already fragile attempt for fiscal consolidation.  At this point, it’s unclear whether the government may have enough support to uphold the veto, so it is possible that they’ll try to delay the election.  Still, the uncertainty over this story will be a definitive variable for Brazilian financial markets, which are at growing chance of becoming disorderly.

The Treasury and the main bank are trying to ensure that liquidity remains ample, but it may not be enough, especially the aforementioned veto is overturned.  The Treasury announced a relationship buyback yesterday. This is welcome information, at least as a sign that the Treasury is ready to step up alongside the central bank to slim against the moves.  The selloff from our market debt curve faster in September, with yields on swaps maturing in January 2017 rising to 15.61% through around 14.2% at the start of the actual month.  The growing fiscal concerns have also led to a clear, crisp steepening of the local debt contour, worsening sentiment locally as well as making the government budget funding even more difficult and expensive.

Here is a quick summary of the unfavourable profile and composition of Brazil’utes internal federal debt, according to the Treasury’s July report.  Approximately, 41% of debt is fixed rate; 33% is indexed to inflation; 21% is actually floating rate; and 5% is actually FX-linked.  Financial institutions hold 26% of the inner debt, investment funds hold 20%, non-residents hold 19% (of which 82% of their assets are in fixed rate securities), and it will be a mix of government and insurance companies.  In terms of maturity, 23% of the inner debt matures in the next 12 months and the average maturity is 4.5 years.  The average interest rate on government debt over the last 12 months is 15%.

At this point, the actual central bank is the nearest the country has to a macroeconomic point, but it is being put to the test.  USD/BRL is nearly at the psychologically essential level of 4.0.  The actual central bank announced the FX credit line auction this week to provide extra liquidity.  This may have helped, but it is far from a decisive development, similar to the decision to increase in Forex swap rollover to 100% a couple weeks ago. 

Rates continue to rise and are now implying several much more hikes to bring rates northern of 15%.  Of course, a lot of this really is risk premium and a function of the dynamics of local rates.  Indeed, the central bank’s survey suggests prices on hold until the end of the year and even cuts in 2016. Although we do not discard further price hikes, the recent moves seem like a clear case of overshoot to all of us, reflecting how politically driven tension (or even panic) in nearby markets can detach property from fundamentals.  There will be an excellent opportunity to receive long-end rates within Brazil at some point, but we do not think it is now.

The pressure factors for Brazil continue to attach and are well documented by the media. We highlight two recent developments.  First, the impeachment procedure is picking up steam and that we increase the odds now to 30%. Financial markets are unclear about whether this is a good or bad development.  We think it’s decidedly negative in the short-term as it may lead to social unrest and huge doubt.  Moreover, the most likely brand new president would be the vice president from the PMDB, which does not inspire a lot confidence.

Second, news that telecommunications company Oi is seeking advice to enhance its debt profile added stress on the corporate side.  The company reportedly hired Rothschild for advice among talk that it was looking to rebuild its debt.

A Decisive Week for Brazil is republished with permission from Marc to Market